The Dow Report in Two Parts
Part 1: Market On Thin Ice Part 2: Follow the Line...
By Tim W Wood CPA, April 15, 2005
This week resulted in enormous technical damage for the markets. From a Dow theory perspective, this decline has served to confirm what should be an important trend change. When I say confirmation, I mean that both the Industrials and the Transports fell below their previous secondary reaction low points.
In this case, that secondary reaction low point was the January 2005 low. This is the first time that this has occurred since the rally separating Phase I from Phase II of this great bear market, which began back in October 2002. If this break remains uncorrected, then under the interpretation of Dow theory, it should serve to confirm the top of the Phase I rally and the beginning of the Phase II decline. According to classic Dow theory, the market is now on thin ice.
Possible Top of Phase 1 and Beginning of Phase 2 The Great Bear Market
Cycles Made Easy with Trend IndicatorTM and Cycle Turn IndicatorTM
I realize that when technical analysts begin to talk their mumbo jumbo on cycles, the average person�s eyes roll back in his head as he begins to nod off to sleep. Well, for about a year now I have been working with my Trend Indicator and my Cycle Turn Indicator. These tools give us a graphical representation of the cycle and all we have to do is simply follow the lines.
- If they are both moving up, then the cycle in the underlying index is moving up.
- If the Trend Indicator is moving up, but the Cycle Turn Indictor is moving down, then the market is in a counter trend correction.
- By the same token, when both indicators are moving down, then the underlying cycle or trend is down.
- If the Trend Indicator is moving down and the Cycle Turn Indicator is moving up, then a counter trend bounce is at hand.
It's almost as simple as just following these lines. I incorporate a few other factors into the equation, but for the purpose of this introduction, I will leave the rules that I use for filtering out. For the purpose of this introduction more rules would just make a simple concept more confusing than it has to be.
Applying the Trend IndicatorTM to Dow Jones Insurance IndexTM
In order to demonstrate these indicators I want to look at the Dow Jones Insurance Index. The chart below is a weekly chart with the Trend Indicator plotted in the upper window. In addition to the direction of the Trend Indicator, I have found that divergences between this indicator and price serve as a serious warning of a cycle or trend change. For example, as this index declined into its 4-year cycle low in March 2003, the Trend Indicator was diverging with price as it made a slightly higher high than its October 2002 low. Then, once this indicator turned up above its trigger line, the new trend or cycle change was confirmed as having turned up.
This indicator had a near miss in November 2003, but nevertheless remained positive until April 2004. As long as this indicator was moving up, then the cycle that this indicator is timed to track remained up as well. When this indicator turned down in April 2004, it was looking ahead at the decline into the cycle low that was yet to come. This low occurred some 6 months later after an 18.6% decline. Then in early December 2004, this indicator turned back up indicating once again that the longer-term cycle was on the rise and that the trend was up.
But, after the Dow Jones Insurance Index made a slightly higher high in February 2005, the Trend Indicator began to roll over. This rollover was again looking ahead at the decline into the next longer-term cycle low. Worst yet however, the February 2005 price high was unconfirmed by the Trend Indicator. This left the Trend indicator diverging with the February 2005 price, which was just the opposite of what happened at the March 2003 low.
So, now we are left with a double whammy in regard to this indicator. We have a divergence that is known to occur at major tops and bottoms, which are also known to be followed by serious trend changes. On top of that, we have the Trend Indicator breaking out of this divergent top below its trigger line. As long as this indicator remains in a down trend, the longer term outlook for this index is bearish, because the longer term cycle has turned down.
Applying the Cycle Turn Indictor to Dow Jones Insurance Index
Now, I want to add another layer by looking at the Cycle Turn Indicator. This indicator is plotted in blue in conjunction with the Trend Indicator. The Cycle Turn Indicator is designed to track the shorter term cyclical movements within the context of the longer term cycle or trend as identified by the Trend Indicator above. So, below we have the same weekly chart of the Dow Jones Insurance Index with the Cycle Turn Indicator.
If we again begin this exercise at the March 2003 low, we find that this indicator turned up just ahead of the Trend Indicator. Given that there were divergences in the Trend Indicator at the time, this upturn of the Cycle Turn Indicator was another clue that the trend was changing, and change it did.
As you can see, this indicator remained positive up into the June 2003 intermediate term cycle high. From this high, this shorter term intermediate term cycle moved down, but the Trend Indicator remained positive. This told us that the decline into the early July 2003 low was a counter trend corrective move and that the longer-term trend was still positive.
Then, in mid July the Cycle Turn Indicator turned back up as price made a brief advance into the early August 2003 intermediate term cycle top. Again, the Cycle Turn Indicator turned down as the intermediate term cycle declined into the late September low. The Trend Indicator remained positive and this was telling us that the decline was a just a counter trend correction and represented another buying opportunity.
This positive action continued all the way into the April 2004 top, at which time both indicators turned down. This then told us that the longer-term trend had turned down. Notice then that each of the rallies occurring between April 2004 and October 2004 were accompanied by an upturn of the Cycle Turn Indicator, but not by a crossover of the Trend Indicator. This was telling us that the longer-term trend was indeed down and that the rallies were counter trend bounces. This bearish action continued all the way down into the longer-term cycle low.
In November 2004 both indicators turned up again confirming that the longer-term trend was once again moving up. However, by early March of this year both, indicators had turned back down. This down turn came after a very brief advance. In the cycles world, we call this a left translated cycle and unless this left translation cycle is corrected, it carries bearish implications. In addition to a left translated cycle, we have the breakdown out of a diverging top seen by the Trend Indicator and confirmed by the Cycle Turn Indicator. As long as the Trend Indicator remains negative, any advance seen by price and the Cycle Turn Indicator is simply another selling opportunity.
This same concept can be applied to any underlying stock index, sector or commodity. I worked to develop these indicators for a number of reasons. One, it makes identifying the cycles much easier for people to see and relate to. Two, with these indicators all we have to do is act in accordance with the direction of these indicators. They take a huge piece of the guess work out. Three, these indicators serve to remove our built-in prejudices or preconceived notions. This turns cycles work into more of a trend-following system. Four, the indicators don't care what the underlying index is. It can be used just as easily on the Dow Jones Insurance Index as it can on the Industrials, the Chinese Hang Seng Index, Lumber, Gold, Oil or Pork Bellies for that matter. These indicators also work well on relative strength charts. In other words, I can tell if a given sector should outperform another sector. Or if soybeans are going to rise or fall on a greater percentage than soy meal. Or if the XAU is going to rise or fall at a greater percentage than the underlying physical metal. The same is also true for comparisons between say the DJIA and the Nasdaq. The applications are endless. Furthermore, these indicators work on different time frames. They can be used on the daily charts to identify shorter-term cycles or on the monthly or quarterly charts to identify even longer-term cycles.
If you find these tools to be of interest, then perhaps Cycles News & Views is a tool for you. I have expanded my service to include these and other indicators that I have developed to assist in cycle turn points or trend identification. Please visit www.cyclesman.com/testimonials.htm to see a sample of what subscribers, who are following these developments closely, are saying.
Tim W. Wood
© 2005 Tim Wood