What Gives with the Dow?

November 1, 1998

The past week in the equities market has been nothing less than tortuous for the bears as we continue to monitor the market for signs of a continued collapse. Our benchmark Dow Jones Industrial Average gave us yet another "October surprise," this time of the bullish variety.

For the week, the Dow was up a modest 140 points, but the month ended with nary a scare in the market as many bears were expecting. In fact, the month, was largely a bullish one leaving short sellers and traders with put options frustrated to no end. While we still view this latest rise as nothing more than a bear market "correction," the Dow tested major overhead resistance today at the 8650-8660 level (hitting an intraday high of 8659 before falling back to close at 8592). We view this resistance level as important because it marks an area where, not only a congestion of technical resistance exists, but because it it this level where a "shooting star" appeared on Oct. 20—a Japanese candlestick pattern that normally forecasts a reversal of trend. Most often, a market will fail to exceed the high of the "shooting star" and will fall to much lower levels before ever again challenging the highs.

 

 

In the case of the Dow, 8660 MUST be overcome before the bulls can have a strong argument of a turnaround. DJ 8750 must be overcome to turn the market officially bullish. The fact that prices today kissed the 8660 level and fell back nearly 70 points at the close leads us to believe this resistance level may not be overcome. Next week will tell us more. More importantly, today's (Oct. 30) action on the Dow Jones Industrials futures contract (basis December) shows what appears to be a bearish reversal pattern known as an "evening star" in Japanese candlestick analysis. This pattern, which we have highlighted in the accompanying candlestick chart, consists of a small "real body" and a rather long lower and upper "hadow" line. It is further characterized by the fact that it has gapped up from the previous day's close and follows a previously bullish day (Oct. 29). This pattern, however, will need to be confirmed on Monday with a close well below today's close. Still, it provides yet further credence for some sort of a decline next week.

For those of you who share our bearish outlook—keep the faith. It has been nothing short of agonizing for bears to maintain a bearish outlook on the Dow of late and surely the best of us have been tried and tested—many, if not most bears, have in fact been shaken out and have returned to the neutral-to-bullish camp. The percentage of investment advisors bearish is low while the percentage bullish is high—a bearish contrarian indicator.

All of these indicators are hallmarks of bear market rallies. Also supporting our still bearish argument has been a plethora of social/political/cultural events of late: the NBA lockout, the Lewinsky scandal, the developing scandals in the financial sector, etc. Volume has remained relatively light on the NYSE, even on the heavy runup days. And market conditions have remained severely overbought, as measured by the cumulative five-day ARMS index and CBOE put/call ratio. The market, if nothing else, is due a pullback next week. Friday's gains were based on the stronger-than-expected GDP figures released by the government, but stock market rallies based on news are almost always ephemeral; we expect the Dow to give back most if not all of Friday's gains early next week.

To be fair, however, we must also consider a bullish alternative to this assessment. The past one week has seen a relative sideways movement in the Dow accompanied by contracting volume. This phenomenon does often follow a large runup in the stock market (as happened earlier in October when the Fed lowered interest rates by an additional 0.25%). Perhaps this is nothing more than a consolidation period before a subsequent runup in the Dow. Indeed, some respected market forecasters are calling for a higher Dow based on this argument.

So which way is the Dow heading over the near-term? The Dow has been in the midst of a major corrective pattern since the lows of early September. All we can do is consider the weight of evidence which should point to the Dow's direction. First, our chart analysis shows two very bearish patterns—an inverted triangle and a larger ascending wedge pattern. Both of these patterns are even more sharply defined in the candlestick chart for the Dow Jones futures. If these patterns prove reliable we should still be preparing for a sharp sell-off sometime in the coming days/weeks.

Cyclically, the Dow will be under extreme bearish pressure during the month of November, so even though it appears investors will escape the infamous month of October unscathed, November still holds the potential to be damaging to portfolios that are heavily exposed to the long side of the market. In fact, records over the last 20 years show that when October has been an especially bullish month (as this one has been), November has turned usually turned out to take back most of October's gains (if not more).

Also troubling for stock market bulls is the fact that the Dow Jones Utilities have provided bearish divergence lately to the Dow Industrials. When the Dow was sinking in September, the utilities responded by moving higher in a bullish upthrust. When the Dow began its climbing phase over two weeks ago, the Utilities registered what appeared to be a bearish key reversal and have been trending lower ever since. When the utilities cannot participate in a broad upmove by both the industrials and the tranportations (as well as the smaller-cap indexes), this is not a positive sign.

Finally, we would be remiss if we did not consider the overwhelmingly weak-looking fundamentals that surround this market. While we tend to avoid the fundamentals in our analysis and stick only to the technicals, we simply cannot ignore the massive leverage and margin debt undergirding this market—a castle made of sand if ever there was one. While the Federal Reserve may have a short-term weapon for fighting off the forces of global deflation—the interest rate—it simply cannot match the immense force of these deflationary forces which eventually steamroll all who try to stop it. Japan has attempted to stop deflation with interest rate cuts and it hasn't worked—Japanese interest rates are nearing 0% and they are still in the mist of a long-term recession bordering on depression. U.S. investors who place their faith in Alan Greenspan and his fabled interest rate ax are surely doomed to disappointment.

If nothing else, the considerable declines in other U.S. indices, such as Value Line, Russell 2000 and Wilshire 5000, almost guarantee that the U.S. will experience a recession in 1999. These indices reflect the health of American companies much more accurately than the capitalization-weighted Dow Jones Industrial Average or the Nasdaq composite average. Eventually, the effects of the significant declines in these averages will be felt in the broader domestic economy.

Clif Droke is the editor of the three times weekly Momentum Strategies Report newsletter, published since 1997, which covers U.S. equity markets and various stock sectors, natural resources, money supply and bank credit trends, the dollar and the U.S. economy.  The forecasts are made using a unique proprietary blend of analytical methods involving cycles, internal momentum and moving average systems, as well as investor sentiment.  He is also the author of numerous books, including “2014: America’s Date With Destiny.” You can view all of Clif's books here. For more information visit www.clifdroke.com.

In the Aztec language the name for gold is teocuitlatl which means "excrement of the gods."

Gold Eagle twitter                Like Gold Eagle on Facebook