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Friday, 21 September 2012

Dow Theory Musings

ES broke declining resistance overnight and we may be seeing the start of a move to test the highs, very possibly to make a double or M top for the retracement that I am expecting to see. The main alternate scenario is that the retracement low is now in and we are seeing the start of a new wave up and that's possible, but I'm leaning strongly against that at the moment.

On the SPX 60min chart the retracement from the highs so far looks like a bull flag, which is a good reason to think that we might see a test of the highs soon. If this rising channel on SPX from the June low is going to hold, then the maximum likely within that channel would be in the 1480-5 area, with the upper bollinger band in the 1482 area today. Equally if that channel is going to hold then the main retracement has not yet got going, and I have a possible target for that at the intersection of rising channel support and the May high in the 1415 area at the start of October:
Will that channel hold though? Looking at my chart of the moves up since the 2009 low the angle of the channel a bit steeper than the drives into the 2010 and 2011 highs and shallower than the drive into the 2012 high. It's worth noting though that the drive into the 2012 high though is probably better viewed excluding the October low, in which case it was exactly as steep as, and slightly shorter than, the move into the 2011 high. I've added that box onto the chart as an alternate.

In terms of the width of the channel it is currently much narrower than any of the moves since the spike up after the 2009 low and may well need to widen as the move continues.On balance if there is going to be a break out of the current channel it would most likely be downwards, to establish a support trendline closer in angle to the last three moves, and it's worth remembering that the channel I was using at the start of QE3 broke downwards on the retracement after the announcement. Here's that drives chart:
I was reading Pretzel's post this morning and he was looking at the NYA chart. There was a possible H&S forming on that chart but the last moves up killed that off and also broke declining resistance from the 2007 high through the 2011 and 2012 highs. As Pretzel noted, there is nothing currently bearish about this chart, and the next obvious move within the rising channel from the 2009 low is a move up to channel resistance at at a test of the 2007 highs, with resistance at the 2011 and 2008 highs on the way there. I'm showing this chart just to note that there is also an argument there that the current SPX channel might break up:
That brings me onto the Dow Theory (DT) musings today. Now there are strong DT divergences here between Dow and TRAN. Dow has broken over the 2012 high and is within striking distance of the 2007 high. TRAN actually made all time highs in 2011, so a new all time high on Dow would end the first DT divergence and confirm that 2011 all time high on TRAN.

Since that 2011 TRAN high however TRAN has seriously underperformed Dow, and is currently well short of even a new 2012 high, and further short still of that 2011 high. What is this telling us? The idea behind this is that when TRAN outperforms Dow the real economy (consumption requiring transport) is outperforming the stock market, and when Dow outperforms TRAN that the stock market is outperforming the real economy. What the current divergence since the 2011 TRAN high is telling us therefore is that the stock market is outperforming the real economy by a wide margin, and looking around at various economic indicators that is obviously right.

Does it still matter though? There has never been a period since Dow Theory was formulated in the 1920s and 1930s when stock market has been openly supported by the US government, but we are now in such a period, with the stated intention by the Fed that they want to boost asset prices including equity markets in the hope that will drag the real economy up with those. It seems unlikely that the real economy will be boosted much by higher asset prices, and may instead be seriously hurt if commodities, particularly oil, take off again in a big way in response to QE3, but we have to consider that QE3 may drive asset prices much higher regardless. Here's the Dow vs Transports chart from the 2011 lows, with a particularly stark underperformance from TRAN in recent days.

It is central to Dow Theory that governments cannot manipulate the primary trend of the market for long, but after the last few years I think that is at best open to question. In the absence of government intervention I think that there is a very good chance that the huge bear topping patterns in many indices (including NYA above) that were forming since 2010 would now be playing out. Instead they are all breaking up one after the other and to that extent the Fed's moves to support the equities appear to have been very successful so far. The obvious question to ask however is how long that can last, and how far up equities can be driven in the absence of support from the real economy? I don't know the answer to that question, but I'm doubtful about that persisting indefinitely. In the short term however the technical bear case on SPX is in shreds, and the current SPX highs don't seem at all likely to hold more than a few weeks at most
Just looking at TRAN, it reached triangle support yesterday and pinocchioed it slightly at the low. A break below that would look distinctly bearish, and open up a test of the June lows there, with TRAN having already given back 66% of all gains since that June low at the close yesterday. The TRAN chart is currently trading entirely at odds with Dow, which has been forming a bull flag near the 2012 highs last week. Food for thought:
Back to the short term EURUSD has broken back over declining resistance from the current high and the 1.30 level. This is provisionally bullish and I'm watching to see whether it can make a short term higher high in the 1.3075 area:
Gold held short term channel support on GC and has formed what looks like a rectangle targeting the strong resistance in the 1800 area. Again provisionally bullish into that test of major resistance:
I've been mentioning a possible retest of the SPX highs all week, and today is the most likely day to see that happen. If we were to see the current high break I'd be looking for strong resistance in the 1480-5 area, and if the current rising channel on SPX is going to hold, then the high from this current move would start the main body of the retracement within that channel.

There is a possibility that the channel will break up however and that needs to be borne in mind. Apologies for being a bit wishy-washy on this, but we are in a transition period at the start of QE3, and we don't yet know how powerful the Fed boosting effect is going to be with equities already so high and the growing divergence between equities and the real economy. I'm expecting channel resistance to hold, but I could be mistaken.

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