Is the Dow Rally a New Impulse Wave or a Bull Trap?

The Dow Industrials average has been on a tear since November 7th, rising over 990 points in two-weeks.  The question we have to ask, though, is if we're seeing the start of a new bullish impulse wave or if this represents an end-of-year bull trap.  Let's look at the daily chart:

Dow Industrials Daily Chart

A short but very productive impulse wave started on February 11, 2016, and that wave pushed the market to a high on April 20th.  If we consider that Wave 1, then Wave 2 ran pretty much through the remainder of 2016.  It was a fairly flat consolidation that culminated with a very tight two-month congestion leading up to the US presidential elections.

The current impulse wave - which may very well be Wave 3 - started November 7, the day before the election.  From there, the market surged skyward, gaining 990 points in a week.  This flagpole formed the foundation for a classic pennant pattern that we appear to have broken yesterday.

Now, the rosy interpretation of this chart places a price target at 19,920 for that flagpole pattern, and it should be obtained relatively quickly - no more than a week or two.  Similarly, the target for Elliott Wave 3 is 20,500, and that lines up rather well if the flagpole target ends at a sub-wave consolidation before continuing to the peak. 

All of this is plausible, especially as we head into a period traditionally marked by a Santa Claus Rally.  That's when this could get a bit ugly, though.  The alternation rule states that Wave 2 and Wave 4 must differ in form and time.  Wave 2 was long and relatively flat.  Therefore, Wave 4 must be short and deep.  Expect a very sharp correction that takes out anywhere from 50% to 61.8% of the Wave 3 gains, and expect it to happen very quickly.  That's as much as a 1650 point drop before Wave 5 commences.


Are there other warning signs on the horizon?  Certainly.  The Dow just achieved an all-time high, but it did so on relatively low volume and with two consecutive narrow range bars.  This implies there really wasn't a lot of enthusiasm pushing the rally, and we may shortly see some climactic action as the large investment houses wind down for the holidays.  This rally would have been much more convincing if accompanied by high volume.

There are also a couple of major events on the horizon that could easily turn this rally into a bull trap.  First, it's a near certainty that FOMC will raise interest rates when they meet on December 14.  In fact, the futures market has priced in a 98.2% chance of a rate increase.  Fed Chair Janet Yellen has also signaled an intent to raise rates twice more in 2017 (data permitting, of course.)  So that would likely mean a June and December hike, and that's precisely what you see if you look at the futures market.

In the midst of this slight tightening of US monetary policy, the UK will be moving towards an Article 50 invocation.  Prime Minister May has targeted the end of March for that major milestone, although the UK courts have added a measure of doubt to the timetable.  Whenever it's done, however, it will certainly have a sobering impact on the EU and British markets.  The combination of Brexit and US interest rate hikes will certainly send shock waves through the world markets. 

So, what does all this mean for us as traders?  Well, that we are in a bullish impulse at the moment cannot be doubted.  We're going to continue playing the long side as long as that impulse remains in effect.  Now, Friday's an early close and will be ultra-low volume, so I'll be sitting that one out.  But once the market opens on Monday, my bias will be to the long side.  The closer we get to 19,500 and then 19,900, however, the tighter my stops will be, and the more I'll be watching for sub-wave 4.  That sub-wave and then the actual Wave 4 will be two that we will want to catch to the short side.  Both will be deep, but both will be short, so remain vigilant.  There won't be much of an opportunity to hop into those waves once they are in full swing.

For now, have a Happy Thanksgiving here in the States, enjoy a nice 4-day stretch away from trading, and let's see where the market decides to take us next week.

DOW and S&P Surge to New Highs But Hold the Champagne For Now

Two of the major indices, the Dow Jones Industrial Average and the S&P 500, surged to record highs today, closing at 18,347 and 2,152 respectively. While the overall market reaction since the swing low on 6/27/16 has been outstanding, and the chart looks very good from a technical perspective, we'd be remiss if we didn't take a step back for a moment to consider the entire landscape.

Dow Jones Industrials Daily Chart

The Chart

Let's start with the Chart. We've clearly pushed through overhead resistance with a vengeance.  Yesterday we plowed through short-term resistance that formed in April, and today we never looked back, breaking through resistance that dates back to May of last year.  From an Elliott Wave perspective, this up-thrust is showing clear impulse signs, both in the current pattern and in the longer pattern that started back in late June.  A very well-defined Wave 1 completed in April, and another well-defined A-B-C flat correction completed June 27 following the Brexit vote.  Since then, we appear to have completed sub-waves i and ii with wave iii of Wave 3 in progress.  If those patterns play out, there's a lot of good news ahead since wave iii has a projection of 18,645, and wave 3 could top out around 19,750.  That, however, requires a lot of optimism, and a lot of chips to fall into place in the world economy, and I'm not ready to suggest that those levels are in range at the moment.

The single item of concern on the chart right now has to do with volume.  It's been declining since the Brexit vote, and that could suggest a lack of commitment on the part of buyers. To push this market higher, we need demand to heat up, and so far - even today - volume is sitting well below it's 200-day average.

Brexit

I'm hearing a lot of talk that today's surge is due to Brexit fears dissipating.  That may be true, especially with news that the issue of the next Prime Minister in the UK has been settled, however it's decidedly premature to dismiss Brexit altogether.  At some point, probably this quarter, Theresa May will invoke Article 50, setting the stage for the Brexit negotiations to begin in earnest.  The uncertainty that will generate is going to impact the global markets despite our pushing the issue to the back-burner for now.

Japan

Another explanation I've heard today is that there's optimism over the announcement of another Japanese stimulus.  While that's certainly good news given the state of the Japanese economy, we've been here before multiple times over.  The Japanese economy has been at death's door for several years, now, and another stimulus without a fundamental shift in the demand for Japanese exports is not going to provide much of a boost.

US Economy

The encouraging jobs report last Friday coupled with today's news that annual growth appears to be 2.4% is greatly reducing the fear of recession looming in the next twelve months.  There's also some encouraging indications that non-residential construction is increasing, and we may even start to see a burst in housing starts.  If we continue to add jobs at the rate seen in June, we'll likely see a boost in consumer confidence.  All of this is great news for the US Economy as a whole, although I'd still like to see a boost in hourly wages, as well as a significant jump in the Labor Force Participation Rate.

Looming over the US Economy, though, is a new concern that interest rate hikes could once again be on the table.  As better data start to emerge, the potential for a rate hike in September increases, and as that starts to gain traction we'll see an impact in the overall market. 

Also looming large is the strength of the US Dollar as well as the resumption in the bear market for Oil.  The dollar will continue to impact our exports and will continue to put negative pressures on earnings for companies with exposure overseas (i.e. most of the S&P 500.)  The resumption of oil declines continues to impact drilling and exploration, which in turn impacts the suppliers of that industry.  These headwinds will continue likely through the remainder of the year.

US Elections

What's still ahead of us is all of the uncertainty surrounding the US Elections.  Neither presidential candidate is anti-business, so from that perspective it's not likely that the Presidential election (or campaign) will be a drag on the economy.  The Senatorial Race, however, is a different story.  Control of the Senate is up for grabs in this election, and with it, the balance of power in the Supreme Court.  A significant shift to the left in those two institutions will have a definite impact on the market as investors and traders seek to adjust to the new dynamic.  Expect the Senatorial Race to add a measure of uncertainty as we enter the 4th Quarter.

The Bottom Line

The bottom line is, there are excellent reasons to celebrate the records set today.  There are also excellent reasons to be very cautious in our trading as we explore this uncharted territory.  There are some significant downward pressures that have yet to be addressed.  Until they are, I recommend keeping the cork firmly sealed in that champagne bottle.  Remember, markets never move in a straight line.  Eight of the last ten trading days have been up, and over half of them have been up with very wide trading ranges.  Expect the bill for that upward movement to come due in short order.

The Slow Stochastic and the Dow Industrials

One of the technical indicators that I really like to use when charting stocks is the 14-period Slow Stochastic, developed by George Lane in the 1950s.  The concept behind this indicator is the theory that prices tend to close near their period highs during an upward trending market, and conversely, they tend to close near their lows during a downward trending market.  The Slow Stochastic will oscillate between 0 and 100.  Generally, chartists consider a security to be oversold - potentially giving buy indications - when the value is below 20, and they consider it overbought - potentially giving sell indications - when the value is above 80. 

The indicator provides two values, and thus two lines, on the chart.  The first line, the %K line, charts the closing price of a security as a percentage of its relationship to the high and low of (in my case) the 14-day period of he stock.  The second line, the %D line, is a 3-day Simple Moving Average of the %K line.  There are several ways to interpret the Slow Stochastic, and I tend to use all of them in conjunction with several other indicators and chart patterns.

Please note!  The indicators (like the Slow Stochastic) do not drive stock price.  They are merely tools by which we are able to understand the actions of traders, and therefore assess if those traders are pumping money into a stock or taking money out of a stock.  The indicators tell us something about the sentiment of the traders, not the health of a company.  In using these indicators, we attempt to determine if - based on trader activity - a price is likely to rise or fall over a given time period.  Indicators are a starting point, but not an end in themselves, and no indicator's buy or sell signals alone will replace the due diligence needed on the overall fundamentals of the security you are seeking to trade.

Here are the signals we can interpret from the Slow Stochastic indicator:

%K / %D Crossovers

Visually, these will jump out at you with a quick glance at the chart.  When %K crosses above %D it's a bullish signal, and conversely, when %D crosses above %K it's bearish.  Like most oscillators, though, you can't rely on just this one signal for buy and sell orders.

%K Crosses above 20 or below 80

This is one of my favorite signals since it has a higher tendency to produce winning trades.  When the %K line crosses from below 20 to above 20, it generates a buy signal.  When it crosses from above 80 to below 80, it generates a sell signal.  Now, be careful here.  As a general rule, I will only take signals in the direction of the prevailing trend, and for that I like to use the slope of the 50-day closing price's Moving Average.  If that slope is increasing, I only take buy signals.  If it is decreasing, I only take sell signals.  Note:  Many traders don't wait for %K to cross back above 20 or below 80.  I do, because I've found that it increases the chances of success despite getting you into the trade one or two periods later.

%K Divergence

This doesn't generate buy or sell signals, per se, but it's a very good early warning signal that a trend may be reversing.  A bullish divergence would be indicated if prices for the security are reaching lower lows, but the %K line is reaching higher highs.  It's an indication that price action is about to reverse and warns us to be alert for a good buy signal.  On the other hand, a bearish divergence would be indicated if price is achieving higher highs, yet the %K line is dropping to lower lows.  It's a warning that a bullish trend may be exhausted and a decline in price is imminent.  In this case, we watch for a good sell signal to either close a position or to open a short position.

So what does all this have to do with the Dow Industrials? Well, let's take a look at both the daily and the weekly charts for the Dow.

Dow Industrials Daily Chart

Look at the time period starting around October 27th.  Closing prices for the Dow were on a very steady upward slope.  The Slow Stochastic, however, was on a downward slope in overbought - above 80 - territory.  The warning signs should be blaring since that's a classic bearish divergence.  Sure enough, the second week of December, the market took a nose dive.  Did you notice that, just before it dove, we had a bearish %K/%D crossover?  You can see the red line - %D - crossing above %K just as the price started to plummet.  That's warning sign number 2.  The final warning came when %K crossed below 80 and, well, you can see what the price action did after that.

So where are we are right now?  The Slow Stochastic is solidly in overbought territory.  %K is above %D and still trending up, but since this is a bound indicator, we know that can't continue much longer.  We don't have any divergence yet, though, so other than being in overbought territory there's nothing else in the Stochastic that would have us concerned.  (A glance at the actual chart also looks pretty good, although we're trading in the upper 20% of the Bollinger Band which is where I start looking for sell indicators.)

But now let's take a look at the Weekly Chart:

Dow Industrials Weekly Chart

As I've noted in the past, the Dow's been trading in a very nice upward channel, bound by the blue resistance line you see on the chart and the 50-period moving average (in red) as support. Let's look at the Slow Stochastic using the 14-period indicator.  The recent down weeks in the market pulled the indicator out of overbought territory and you can see the subsequent (temporary) drop in price.  (Remember, the slope of the 50-period moving average is up, so I'd ignore any sell signals here.  Tighten stops, or wait for a good long entry, but there's no way I'd go short on any security showing that strong an upward slope.)  The Dow bounced very nicely off support again, and we have a very nice bullish crossover following the close at the end of this week.  Looking at the lows of the Stochastic, they are forming a nice upward trend line as well, matching the price action of the lows, so there's no divergence, either.

The only warning signs on this chart, in fact, is that we are approaching the resistance line once again, and we're trading in the upper 10% of the Bollinger Band.  Whether or not we bounce off resistance and head back down or whether we break through resistance and surge upward will depend on the geopolitical situation as well as the economic indicators released in the coming weeks.  Earnings season is essentially over until late March and April, so we won't have earnings announcements pushing the market for the next couple of months.

One last item to note, though, is about the use of any indicator to analyze a market index.  Remember that the index - in this case the Dow - is based on the price action of the stocks that comprise that index.  In today's age of computerized trading, however, the technical analysis of the index itself is used by traders to gauge whether or not they should take some profits in the stocks that comprise the index or whether or not to enter new positions within that index.  Never forget that it's the price action of the underlying securities that drives the index - and thus drive the indicators that we use to analyze that index. 

Market Volatility Is No Cause for Panic

"Volatility" has been the daily buzzword in the market for at least the last six weeks.  Certainly we've seen some wild and wooly daily swings, as traders on both sides of the pond react to seemingly random bits of news.  If we take a step back to look at the Dow Industrial's weekly chart, though, we can plainly see that there's no real panic in the market, nor is there any real sense of troubled times ahead for 2015.  Take a look at this chart:

Dow Industrial Average Weekly Chart

A few things should pop right out as us:

1. The Dow is trading well above its 250-period moving average (Green line).
2. The Dow is trading above its 50-period exponential moving average (Red line.)
3. The slope of both the 50-period and the 250 period averages is at a consistent upward (bullish) angle.
4. The 50-period line has been acting as support since late 2011.
5. Resistance - the green line - is proceeding upward at a very healthy slope and - since January 2014 - has been running parallel to the 50-period line.
6. Volume has been relatively stable since late 2013 and is not showing any of the wild increases that would signal a trend change.
7. We're trading at a support level right now (top dashed blue line) and there is a very strong support level around 16,500, coinciding with a 23.6% Fibonacci retracement line.
8. The weekly chart is still experiencing higher highs and higher lows.  That is the textbook definition of an uptrend.

Will there be more downward movement in the next week or so?  Sure.  There are plenty of global pressures out there pushing us downward, and I expect us to at least test the 50-period average around 16,900.  That point, however will be a fantastic buying opportunity. If the resistance trend line continues, the next test of that resistance may be above 18,500.

Now, there's certainly plenty of headwind in the global market.

• Greece is in a staring contest with the ECB and with Germany over what to do with their debt.
• Russia's economy is in meltdown.
• Europe's economy has slowed to a point hovering just above a recession.
• China's GDP, while still a very healthy 6.7%, has slowed considerably.
• The Middle East, Africa, and Latin America are all stalled.
• The US Dollar continues to strengthen against other key currencies.
• A labor dispute at the ports on the US west coast is hampering imports that should otherwise be soaring.
• The collapse of oil prices is starting to put pressure on numerous industries, threatening the growth in the otherwise healthy US economy.

Despite all that headwind, where else would investors put their money?  The US Treasury is always a safe haven, but with interest rates still near zero and not likely to increase until late 3Q15 there's no real profit to be made there.  The European treasuries aren't paying anything either.  Russia's bonds are paying double digits right now, but it's anyone's guess if you'll ever see your investment again.  European stocks are in turmoil as is the Japanese market. Where else will that money go?  As global conditions worsen, expect the US equities market to become the safe haven. 

Take advantage of these downturns in the Dow, the S&P, and the Nasdaq.  They represent the best buying opportunities we've had in a while.  Don't fear this growing volatility; embrace it.  Every dip in prices in the coming weeks is your opportunity to enter this still healthy and still growing bull market without paying too high a premium.  This bull has not yet run its course, nor do I expect it to end in 2015.