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Turning Points

During the past two weeks, the action of the stock market has been positive. The momentum indicators (stochastic and MACD) which had flattened out and indicated that a short term rally was imminent did not disappoint. Also, the breadth indicators suggested that there was accumulation taking place, even though it was not yet being reflected in the price action.

The advance/decline has continued to register impressive readings for 9 consecutive days of net advances thereby sending the McClellan oscillator to record levels. In the past, this kind of action has preceded an important up trend, but so far, the price momentum has not followed suit. Which of the two is giving us the true picture? It has been suggested that breadth statistics have become distorted by the great number of bond ETFs that are currently traded on the NYSE, and that it is no longer as reliable an indicator as it once was. That could be! But in the final analysis, price action is the only true determinant of market behavior, so this is what we need to scrutinize. With that in mind, let's do our customary dissection of the different aspects of the market, and see what it tells us:

Structure: Looking back at the market pattern since March '03, the recent correction looks more and more like a wave 4, with wave 5 to come. Looking further back to October '02, we could be completing wave 3 of a larger pattern, and this would mean that we could expect higher highs not only in the short term, but also at some point in the future.

You can certainly see this as a possible structure when you look at the weekly chart of the S&P 500 which appears below (courtesy of Stockcharts).

I am not a strict "Elliottician" (I hate that word!), but I recognize that Elliott discovered a basic, repetitive market pattern which can be of help in forecasting. Judging by the fact that the great majority of Elliott Wave Theory forecasts that turn out to be incorrect, even those made by some of the leading "experts", it is obvious that the theory he proposed is either incomplete or little understood. However, it is still the best market structure model available. So we'll keep the above scenario in mind and revise it when it's called for.

Momentum: Last week I mentioned that the momentum indicators were oversold and appeared ready to turn up.

In retrospect, the lows of the move had already been made and the S&P had already broken outside of its short term down trend line, but we had to wait for the DJIA to do the same before buyers came in.

I also mentioned that the oscillators were more oversold than bullish and, although we have definitely reversed the short term trend, the move still appears to lack conviction and it cannot be said for certain that the intermediate correction is complete. Confirmation will come only after the down trend line drawn across the two tops is decisively penetrated, AND the 1150 level on the S&P has been overcome.

In the above weekly chart of the S&P, the stochastics is oversold while the MACD is undergoing a normal correction from an overbought condition. The readings indicate that the correction has just about run its course.

Cycles: As you know, I have been looking for the bottom of phase #1 of the 120-week cycle normal two-phase pattern. Perhaps this is what is taking place presently, and if so, the correction should be over and a continuation of the longer trend should resume. There is also a short term cycle low due in roughly two weeks which will eventually act as a restraining factor on the short term trend of the market.

Leading indicators: GE has already broken through its intermediate term down trend line. It must now overcome the former 31.85 high to confirm the resumption of an up trend. The Dow transports are in phase with the industrials, and the QQQ is in phase with the S&P. There is no divergence, positive or negative.

Summary: The market appears ready for a short phase of consolidation before attempting to move higher, and there is no sign of danger of a down side reversal of substance at this point.

Is there a reliable way to determine the long term trend of the stock market?:

In the 1960's there was an excellent technical analyst by the name of Edson Gould who published a newsletter called Finding and Forecasts. He had two important criteria to determine the main trend of the stock market. One was the decennial pattern of stocks which, amazingly, appears to repeat itself every 10 years with each year of the decade having a predictive value for stock prices. (Note: This is not the same thing as the 10-year cycle which is a separate rhythm entirely.) The second one was what he called 1/3 and 2/3 speed resistance lines which were drawn from the high or low points of an important move to the 1/3 and 2/3 point of the vertical line extended from the high to the low. The latter was his primary tool to determine if the longer term market trend was up or down.

The construction of these trend lines can be refined by using the Fibonacci .382 and .618 ratios (another aspect of those amazing Fibonacci ratios) instead of 1/3 and 2/3. The technique is simplicity itself and is valid and interpreted in the same manner for any time frame.

The analysis is as follows: both lines will tend to serve as support or resistance lines. When used in conjunction with a weekly chart to determine the longer term trend of the market, penetration of the steeper (.618) trend line indicates that an intermediate term correction is still under way, but that the long term trend may be intact. However, when the .382 trend line is violated decisively, this means that the longer trend has reversed.

I have included a weekly chart of the DJIA going back to 1998 with the speed resistance lines drawn for both the down trend from the top of the market in 2000, and from the lows of October 2002. You can clearly see that the long term down trend line was decisively penetrated in September of '03, and that the up trend line is in no danger of being penetrated to the down side any time soon.

We should also remember that in this rally, the DJIA retraced .786 of its entire decline. This is a sign of long term strength.

It is also interesting to note how the speed resistance lines, in both cases, serve as a resistance line until penetrated, and conversely as a support lines as well. The recent correction has ended right on the .618 up trend line.

Looking at the second criterion used by Edson Gould -- the decennial pattern -- we find that stocks tend to make a major low in either the 2nd or 3rd year of the decade, and continue to rally late into the 5th year, making another important low in the 6th or 7th year, and have a final rally into the 9th or 10th year before starting another major decline into the 2nd or 3rd year of the next decade.

Is there any logic for this recurring pattern, decade after decade? Is there any logic for market cycles? Is there any logic for Fibonacci ratio relationships and repetitive fractal patterns? None that the human mind can discern but, perhaps this market behavior is caused by a "higher logic": the Natural Law to which R. N. Elliott referred!

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