Dow: Worst is Yet to Come
Several months ago I warned subscribers of The Sovereign Strategist that with the economy deteriorating and the Nasdaq having plunged by thousands of points, the Dow and the S&P 500 would surely soon follow. While that forecast has since come to pass, recent action in the Dow suggests that the worst is still to come.
In our New Economy High-Tech Era, one might be tempted to suggest that the Dow has become less relevant. But the fact remains that the Dow represents "the market" to most people. It is the index with which the man in the street most identifies and it is still quite representative of our overall economy. Therefore, activity in the Dow has a very substantial bearing on investor psychology and market sentiment.
While the broader market is clearly in a bear market, the Dow has so far managed to avoid the technical definition of a bear market, i.e. a 20% drop. But that's just semantics. Semantics can be an engaging pastime in the ivory towers of turtle-neck, leather-patch-on-the-elbow academia, but for the purposes of speculating our way towards profits, they're irrelevant. If it walks, talks, looks and smells like a bear, it's neither a duck-billed platypus nor a ring-necked purple dimpled hippopotamus. And it's certainly not a bull.
The Dow took quite a drubbing in March, finally breaking down from a large, 2-year trading range . The index very narrowly averted posting its worst first quarter since 1960 by only about 50 points. Had the Dow gained 30 points instead of 79 points on 30 March, it would have been the Dow's worst first quarter in 41 years.
While the rebound from the recent slide incited cries that this must surely bet the bottom, from a technical perspective the Dow remains riddled with structural weaknesses. The media can argue amongst themselves as to whether or not a bottom is in place, but a thorough examination of the charts clearly demonstrates some rather ominous signs.
DJIA Monthly 3/30/01
Let's begin with a look at the long-term monthly graph. Notice the steady upward climb of the Dow over the course of years. Notice that the upward sloping progression extends from 1982 to 2000, disturbed only by relatively quick and brief anomalies: the crash of 1987 and the downdraft in late 1998.
But then look at what happens beginning around April of 1999. Something has changed. Drastically. We see the beginning of a 2-year pattern that is completely unlike what we have seen in the prior 17-18 years. The upside momentum has slowed, the all-time high is made in January of 2000, and the long standing pattern of higher highs and higher lows draws to a close. We now see an extended sideways pattern. The market has deviated from its usual pattern. It has changed.
When something changes, it is not the way it used to be. The Dow used to be in a bullish trend. But this 2-year sideways pattern demonstrates that the trend is now different. What's different from a bull market? Either a non-trending market or a bear market.
Add to that the fact that in January of 2000, the monthly graph posted what is known as a "key-reversal". During that month, the Dow made a new high, reversed suddenly and sharply, posted a range larger than the previous one, and then closed lower than the previous month.
What that means when you break it down into market activity is that the market climbed to a new high but found no more buyers. In fact, the buying dried up so thoroughly that the new highs were forcefully rejected. New buyers realized they were left "holding the bag", a bag that no one else wanted, and they ran as fast as they could for the exits. The selling was powerful enough to reverse all the previous month's gains, leaving the Dow to close lower, and sharply off its high - a high that has yet to be exceeded or even tested.
On to more bearish signs. Notice the steady pattern of lower highs and lower lows since that all-time high. What does this imply? That every rally has been a bit weaker than the last and that every decline has been a bit stronger than the last. Fewer and fewer buyers have materialized at the highs, while more aggressive sellers have entered with every decline.
Another exceedingly bearish sign: while I haven't shown it on this graph, volume throughout this pattern of lower highs and lower lows has been HIGHER than ever before. In fact, volume has been increasing during the time that buyers have grown weaker and sellers have grown stronger. That is a clear indication that selling pressure has become more aggressive and frequent while buying has weakened.
One might argue that this 2-year sideways pattern is merely the formation of a base prior to the next leg higher. But the increasing volume on declining prices suggests just the opposite: distribution. Strong hands are selling off stocks to the weaker hands, distributing their stock, taking profits, and getting out of the market. Why? Most likely because they know it is overpriced.
As if all those bearish signals are not enough, consider the following. The Dow has been trading below its 200-day moving average for several weeks now, always an ominous sign for the long term trend. But it gets much worse. You see, the Dow recently penetrated its 200-WEEK moving average more decisively than it has in a very long time. In fact, the Dow actually CLOSED below its 200-week average for the first time in a VERY long time a couple weeks ago. (It has since rebounded above it).
The last time that the Dow flirted with its 200-week moving average was in late 1990 when it briefly dipped below it, but didn't close there, and then rebounded and continued its upward course. Prior to that, the Dow just barely touched its 200-week average during the crash of 1987. That was the low, and it rebounded higher from there, the long-term bull market still intact.
Clearly, the 200-week moving average has been a very significant support level for this entire bull market. In fact, the last time that the Dow has been decisively below its 200-week average (prior to this March, that is) was in 1982, just before the biggest bull market in history began.
The fact that the Dow has had a week in which it actually closed below its 200-week moving average for the first time since the bull market began in 1982 is a HIGHLY significant event. It is a major signal that something has drastically changed in this market. It is a very clear indication of WEAKNESS, the kind we have not seen in almost 20 years.
But what of the recent rebound? Is it not significant? After all, the Dow has retraced a substantial portion of its recent slide.
Take a look at the daily chart and notice where the Dow has recently broke down from a long sideways trading range. Notice that the Dow broke sharply below that range and has since attempted to rebound toward it. That is a very typical reaction noticed in technical studies of the markets and individual stocks. When the market breaks down from a major topping pattern, a "return move" is very common. Those who anticipated the decline and profited from it are covering shorts while those who see the relatively "cheap" prices are eager to buy a "bargain". That stems the decline and causes a rebound toward the topping pattern.
DJIA Daily 3/30/01
Generally, prices will not move back into that pattern. Those who bought within the range are looking to get even, so they sell, while those who got short prior to the break sell on expectations that they'll be able to repeat their performance. The actions of those two groups keep a lid on the advance and it isn't very long before the market begins to fall again. Of course, if prices do move back into the range, it is often an indication that higher prices are forthcoming. A subsequent break-out above the range is a powerfully bullish signal.
The point of my explanation is to demonstrate that while the recent rebound looks bullish at first glance, it is in fact a totally normal and expected response within the context of a BEARISH scenario. It is not an indication of bullishness but in fact a confirmation of bearishness. It is exactly what we would expect to see in a market that is breaking down.
Must the Dow necessarily continue to slide given the evidence that I have disclosed? Of course not. If your car begins to sputter and choke, it doesn't necessarily mean that a major breakdown is in the works. Nothing has to happen. But it is a good sign that something is wrong and that signal should not be ignored. When the market begins to sputter and choke, you'd be well advised to take a good look under the hood and make some preparations before you're left without a ride, so to speak.
Technicals are a good indication of the current state of the market and don't necessarily define the future. Nonetheless, from what I have pointed it out, it is quite apparent that the Dow has demonstrated some very significant structural weaknesses, the sort that are unlikely to be undone by a mild downdraft. As they say, "the bigger they are, the harder they fall." Large expansions are generally followed by large contractions. Similarly, with the Dow having risen sharply for 18 years, it is highly unlikely that the following bear market will remain as mild as it has appeared so far. Indeed, it is a good bet that the worst is yet to come.
Mark M. Rostenko
April 9, 2001
Mr. Rostenko is a veteran of Chicago's Commodity Pits and editor of The Sovereign Strategist financial newsletter at www.sovereignstrategist.com
Copyright 2001 by Mark M. Rostenko and The Sovereign Strategist
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