Recap on Last Week
Most of the major news this past week focused on US Dollar announcements. Fed funds rate stayed unchanged, so no expected rate increase in the immediate future, or such is the assumption. Despite relatively tame news, the USD did drop against most, if not all major currencies on Wednesday’s monthly Fed announcement, arguably due to other factors like unemployment expectations. This week we have existing home sales (already posted today, and up slightly), quarter to quarter GDP (Wednesday) and unemployment claims (Thursday). An interesting week for the Euro with French and German manufacturing data as well as the Asian bread-basket New Zealand, with trade balance on Thursday. Should see a number of currency pairs bouncing around, but all in all, likely nothing trend-setting.
I like to look at how volume changes on the major indexes from week to week. Dow Theory states that volume increases in the direction of the primary trend, so if price is rising while volume is falling, we could be due a correction. Let’s compare the change in the 3-month rolling average on volume.
Dow Industrials – 3mo Average Daily Rolling Volume 95,722,220. A week ago’s 3mo Average 98,175,456. Down about 2.5%. Trend up with volume decreasing – assume possible reversal/correction – Data per CNN Money
Dow Transports – 3mo Average Daily Rolling Volume 15,590,553. A week ago’s 3mo Average 15,675,265. Marginally up 0.5%. Trend down with volume increasing – assume continuation down – Data per CNN Money
On a more tangible note, last week was interesting for gold. The Texas Legislature passed a gold repatriation bill, deciding to build their own in-house, or in this case in-state depository, requesting deliver of roughly $1 Billion worth of gold returned to the state from the Fed depositories. Texas has always claimed a long-standing right of separation from the Union, and maintained, at least in terms of lip-service, a sense of independence. Always exciting to see action back words, and if anyone was going to be first, it’s not surprising it was Texas. I think back on the great German gold repatriation out of the Fed from a few years ago, and of course the Fed’s inability to deliver (at least in the immediate sense). This is a lot less gold, $1 Billion is around 26 metric tonnes, so we will see how the Fed handles it.
To some extent this reminds me of the Swiss’ breaking the peg to the Euro earlier this year. The Swiss tend to be the most independent nation in Europe, as Texas claims in the US. Are the more conservative minds out there seeking a little bit of safety while the less savvy seek to stretch profits? We’ll have to see.
Comparative Averages, Divergence, and Speculation on Trend Reversal
One major tenant of Dow Theory is that the Transports and the Industrials tend to move in the same direction. I also include the Utilities generally in line with the Transports. I would argue that since the Industrials are the heaviest traded (including both the most speculative as well as leveraged positions) of the three, that one could assume Transports generally should lead the charge when a trend may be shifting. The reason; if a company is shipping fewer goods then your transportation companies are seeing diminished revenue. The manufacturing and industrial companies however, may continue to rise in share price due to speculation and market activity, instead of relying solely on what actually matters, revenue and income. I discussed this more previously (CLICK HERE). This is why we see P/E ratio’s up in the 20’s, as opposed to numbers more reasonable, between 7 and 13.
So let’s dive into some charts and see what supply and demand is telling us. But first, a look at divergence. In the chart below, I’m going to start from left to right on the notes I’ve made on the charts. First I wanted to give an example of divergence.
*Years ago John Hayden put together his book RSI: The Complete Guide, and in my opinion is a must read for all investors and traders. A simple Google search should also offer opportunity to download for free, or I’m sure you could find a copy on Amazon.
Arguably the most important aspect one must remember when trading divergence against any indicator (and below I’ve used both RSI and MACD) is that divergence generally leads to exactly what the word means. Divergence does NOT signal a trend shift, but instead a respite. A “divergence” from the trend, assuming continuation (a hiccup, a bump in the road, a correction, call it what you will). As shown below, we have divergence, where price is making higher highs, but the indicators are making lower highs. This followed a deep correction, and then finally a continuation up. Exactly what it is meant to signal. Divergence often offers two short term trades, first is the correction down (in this case a sell order), and second is the position shift back to trend (in this case a buy order). Regarding the other points I’ve indicated on the chart, we’ll get to those in a moment.
But first, let’s see a similar pattern in the Dow Industrial chart below. You see the exact same pattern in the Industrials into a correction down, and a strong continuation up. This is textbook divergence, and for short term traders offers lucrative opportunity In fact, there are many successful traders that rely almost exclusively on some derivative of divergence trading, and are rather successful at it. As we continue following the chart, we are currently forming a Rising Wedge pattern with Divergence. This gives hint at another correction down, I’ve listed a few potential targets based on engulfing FTR supply/demand levels. I would argue based on my trading rules the Target 1 and Target 3 are the strongest. So by looking at the chart below, it can be assumed a brief intermission to the trend is around the corner.
For repetitions sake, here’s a similar picture of a broader index, the S&P 500.
At the very least, I think it’s fair to assume a deep correction on the Equity indexes in the short to intermediate future. All potential targets I’ve listed above assume a simple divergent correction against the rising trend. However, despite all my trading rules I follow, there is one that overshadows all, and that is Primary Trend (a trend lasting a year or more).
We have been in a primary bull trend for a while now. Most people that as a rule hold only long-term bullish investments and had lost 40-50-60% of their positions in the 2008 crash are now at profits again; let’s be honest, this feels pretty good, right?. As we started our discussion above, I put forth the theory that the Transportation Index leads the way for primary trend in equities. So before we take a sigh of relief from the above pending Divergence trade in the Industrials, and the assumption that despite the occasional divergent correction, the Dow, S&P and other equity indexes or funds are marching their way up indefinately, let’s look at the Transportation chart one more time.
While I started this conversation discussing divergence, it’s important to remember that assumptive indicators only work some of the time, the good ones work most of the time, and nothing ever works all of the time. Trading, like poker, is a game of probabilities. As we let our eyes scan past the previous divergence example we discussed and continue looking to the right on the above chart, I’ve marked a support line based off what I call a First Engulfing FTR, this is the thin, dashed, horizontal line. Look about halfway up the continuation line for where it starts. On the day we had a green candle up that broke above the previous high (engulf), the following day we had a small drop back down, this the the FTR, or Failure To Return, meaning the price failed to continue going down, the bulls have officially overpowered the bears again, and price continues up. This FTR now becomes a new support level. Ultimately as you can see this level was touched 3 times, and finally breached on the 4th (as indicated, Broken Support). Once support was broken, price inevitably trailed down. This previous support line has now become resistance, and should likely be tested again, although this time, from the bottom instead of the top.
So if my theory is correct about Transports leading the charge, one would also assume that the Utilities follow similar path to the Transports, since they both carry less speculation and leverage than the Industrial and Manufacturing. Below we see a similar story in the Utilities. I left any Divergence off of this chart, since I’m sure you get the idea by this point. In similar fashion, support was broken, the price consolidated sideways until it made a definitive move down, support now becomes resistance. I’ve marked two short-term targets. Also, my entry point for a short trade is NOT the resistance line we are bumping against now, as I do not post pending trades on this research and information site.
First I think it’s important to re-beat the dead horse. Trading and Investing are NOT the same thing. I trade a lot of things, regardless of Primary Trend. I never invest against the primary trend, I never put investment money into a trend reversal. If the reversal itself is the first entry point, then from an investing standpoint, I’m looking for the second. My smaller trading positions are for playing reversals for smaller, short-term profits. With that said, I believe I see two potential trades here, first is a short term consolidation down, and second is the move back up. However, if the continuation back up does not hold, then my loss on this trade becomes a best-case scenario. The second trade loses me money because it’s a true trend reversal. Losing a small amount of money on a speculative trade is a blessing, as it could perhaps signal reversal of trend. Another 2008-esque market correction should make you salivate not panic. These moves offer excellent investment opportunity for a prolonged trend reversal in the markets as a whole.
I adhere loosly to the Efficient Market Hypothesis (although I’m realistic), and a belief that the steam will come out of the US Equity markets. This is the nature of how markets operate; corrections are healthy and are opportunity. Whether this is rollover or not is irrelevant, as long as the principles remain intact, that no market goes one direction forever. I also believe Fibonacci is hard to argue with, albeit I wonder if this is simply confirmation bias, meaning people trade Fibonacci numbers assuming they are naturally occuring events, but it’s the adherence to them that forces them to occur. But I’m no philosopher (although let’s be honest, you spend enough time in the markets you realize philosophy, social pressure, herd-mentality, etc. all play an intricate role).
Do I care if this is a simple consolidation as the Dow makes its charge toward 20,000? No, I’m playing that side too. But signals toward a massive market change should warrant attention, even if you pass through them safely. My excitement over the next 3-6 months may be all for naught, but that doesn’t matter. What does matter is the willingness to be tentative and ready at all times for these signs and signals. The Bible talks about tending your lampstand at all times, or being a watchman on the wall, as you do not know when the enemy approaches.
Market corrections are not the death of an investment account, complacency is.