When markets go sideways for a few weeks, we are tempted to believe that there is no risk. Reinforcing our complacency, economists and gurus espouse that the market is just taking a breather in its eternal upward journey. While the next short-term move may be up, a thorough study of history and economics makes it plain to see that this upward climb is nothing more than the pause before the plunge of a historical series of bubbles. That being said, is there anything the investor can look at to help him see this topping process?
As a believer in the power of the picture, in this report I am going to show several shorter-term charts supporting the premise that we are currently at a cross roads for the rebound that has occurred since October 2002. In so doing, we will look at the markets from several angles using some of the best minds in Elliot Wave and Dow Theory.
First, we start with the big picture. On page four of our February newsletter, we note a Dow Theory sell signal on January 21st of this year, and then we note a reconfirmation of the Dow Theory sell signal on April 14th in a publication of the same article in Liberty Watch magazine. So, has the market melted off? No. Should we as investors ignore the oldest trading tool in the US markets? Only if we think we're in a "new era" and things that have assisted investors in reducing losses for over 100 years are not needed in today's markets.
Tim Woods gives excellent comments on Dow Theory and has a good website for learning more about Dow Theory history. Tim points out that nothing has broken the Dow Theory sell signal that was established and reconfirmed earlier in the year.
In order to invalidate the sell signal, we would have to see a buy signal confirmation where both the transports and the industrials would breakout to new highs. So looking at the picture above, we know that since March 7th we have not broken to new highs in the Dow Jones Industrials or the Dow Jones Transportation indexes.
Secondly, let's look at the Baltic Dry Index. The Baltic Exchange, based out of London since 1744, uses a panel of international ship brokers and provides daily assessment on 42 wet and dry shipping routes to assess the cost of shipping worldwide. The Baltic canvasses brokers around the world and asks how much it would cost to book various cargoes of raw materials on various routes, considering variables such as the type and speed of the ship and the length of the voyage. Since it takes almost two years to get a ship up and operable in the oceans of the world, the supply of ships is quite inelastic, and thus significant increases in demand can make shipping prices jump quickly, and declines in demand can have the opposite effect.
This chart, produced by Elliot Wave International, reveals that shipping prices have plunged since early December 2004.
Looking at the chart above, the first thing we see is how volatile this index has been over the last two years. However, the 52% plunge in this worldwide shipping index over the last six months, certainly does not bode well for the global economy.
The next two charts are adaptations of Richard Russell's Dow Theory Letters June 6, 2005 daily comments. The recent action of the retail stock index continues to support our position that the current rally from the end of April is running out of steam. Declining volume on a rally is indicative of a reversal and is therefore bearish. The moving average convergence-divergence (MACD) is currently showing overbought, above one, and due to correct.
Not only is there frailty in the retail sector, but even the supercharged housing sector is showing its Achilles' heel. While hundreds of articles continue to be written about a housing bubble from an economic standpoint, technicians look for signs of a weak spot in different ways. One classic sign of a reversal is a double top. When a market hits a point, comes off, and then runs out of steam within the same vicinity, this is signifies a likely turn down. The housing index, shown below, appears to be sending some sings of fatigue.
In keeping with the posit that we are close to a top, the last technical tool I want to show you today is Fibonacci numbers. Though this may sound unfamiliar to many, traders use this tool extensively every day in every type of market.
Fibonacci is a mathematician who lived in the early 11th century. He is known for his Fibonacci Sequence and the Golden Ratio. I will briefly explain them and then we will see how they work in the real world of money.
The Fibonacci Sequence is: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610... etcetera. The pattern is simple yet brilliant. Each number added to the next number in the sequence gives you the next higher number. That is, 1+1=2, 1+2=3, 2+3=5, 3+5=8...et al.
The Golden Ratio is a derivation of the Fibonacci Sequence. Phi (not to be confused with Pi) is the Greek number for the Golden Ratio. In the Fibonnaci sequence of numbers phi can be found by dividing one number into the next lower number. So, 21/13 = 1.6153. Again, 89/55 = 1.6181. And once more, 377/233 = 1.6180.
Likewise the reciprocal of phi is calculated by dividing the lower number into the next higher number in the sequence. That is, 13/21= .6190, 55/89 = .6179, and 233/377 =.6180.
Don't get too bogged down in the math. It is sufficient to know that these relationships exist.
Dr. McHugh is probably one of the best I have found in constructing markets through Fibonacci patterns. For example, by counting various Fibonacci numbers from previous highs and lows over the last two years, a person could see that there was a clustering effect occurring around the end of May 2005. Based on this clustering of numbers, Dr. McHugh predicted that the markets should reach a turning point by the end of May.
He also charted patterns using various Fibonacci ratios (again a tool used by many professional traders) the closer we got to the end of May.
Just as the Golden Ratio, 1.61 and .61, shows advancement and retracement levels, other Fibonacci ratios show other common retracement levels at .38, .50, and .78. In May, the SP500 began forming a pattern called a Diamond Kite where each side was coming together on June 2, to form a kite. You will notice the number of days between market turning points in the SP500 were 13/17 or .78.
During May Dr. McHugh also began to see patterns forming the NASDAQ, and coming to a head on June 4. Since this was a Saturday, the turn would not occur on exactly that day but on a trading day near that date.
So June 2nd and June 4th have come and gone. Did anything happen? Was it a turning point? Take a look at the charts below.
And how about the NASDAQ?
So while Wall Street tells us that it is impossible to "time the market" and beat the index, declining markets in history painfully disagree. We can either review the warning signals flashing before us, or blissfully assume that making no decision is the "safest" decision over the long haul. History has shown us, even as recent as 2000, ignoring the flashing road signs can do permanent damage to our finances.
Investing is not easy. It requires a lot of ongoing work, and an unending amount of patience. Don't be fooled by current bull market hype. This is a very dangerous market, and investing is not a crapshoot.
For More information on the Baltic Exchange and the Dry Index visit the Baltic Exchange and read this article from the fall of 2003 on MSN.
The following are people and sites that I used for this presentation. To learn more about their services you can visit their sites.
My charts were prepared through the services found at www.stockcharts.com.