Wednesday, 24 August 2011


So it's a little red box on a stick...
what's the big deal?

Amidst the recent slew of disorientating market swings, I've been keeping a steady eye on some key technical indicators, waiting for a signal to buy for what I suspect could be a multi-month bounce.

One of the most unusual features of this sell-off has been its intensity and volatility.  So I wanted to check to see whether, coming off a multi-month high like we saw in April, such price action has historically indicated the start of something more ominous over the long term.  After hours of research, I confess I am none the wiser.

But in the process of scouring my Dow Jones weekly charts all the way back to the 1920s, I did notice something rather unusual.

Dow Jones Industrials Average, weekly to Aug.24th 2011.

Take a look at the candlestick highlighted by the green dot.  It's unusual for two reasons.  Aside from the fact that it bounced off its declining 200-week moving average (cyan line) which is a rarity in itself, the entire week's price action took place below its lower Bollinger band, shown in purple.

For those who are unfamiliar with Bollinger bands, they capture the range of volatility a stock or index has shown over a particular period using a statistical measure known as standard deviation.  On normal settings, these bands encompass the great majority of market movements.  So when an entire week's price action takes place below the lower band, it indicates a level of unremitting selling pressure which is highly unusual - so rare in fact, that it has only occured 8 times since 1929.

Here are all eight instances:

1929 & 1930







On even a cursory study, one conclusion is crystal clear: 

  • stocks are likely to be at, or near, a medium-term low.

If this signal were a lone bullish light in a sea of technical darkness I may have been inclined to discount it.  But it is backed up by almost all of my technical indicators, which are showing unsustainable extremes in downside momentum, breadth, volume and sentiment, a combination which over the past twenty years has led unfailingly to higher prices in the medium term.  Here are some further observations:

  • The minimum price rise from the above examples was 19% in 1930, from the low of the first 'green-dot' bar to the subsequent peak.  

  • The maximum loss was 10% from the low of the bar, in 1929.  Most instances showed losses from 0%-2%.  

  • The minimum upward 'distance' the Dow travelled was to its 20-week simple moving average at the mid-line of the Bollinger bands. Currently that line is falling towards 12,000, around 700 points higher than where we sit today.  (12,000 also happens to roughly coincide with the 200-day moving average and the breakdown from the Head-and Shoulders formation highlighted in my previous post.  Together these should form powerful resistance).

  • Most often the index bounced all the way to its upper Bollinger band before the longer-term trend, whether bullish or bearish, asserted itself.

And long term there do remain huge question marks.  As you know I have my view, but sadly, this little candlestick was no objective guide to whether we were going to rise or fall over the next several years (3 examples appeared at the beginning of hideous long-term bear markets, while 5 marked either the beginning or the continuation of powerful bull markets).

Nevertheless, if you are (or you're prepared to act like) a trader rather than a pure long-term investor, the current setup appears to be a compelling low-risk opportunity. Could we push lower still before a rally?  Yes.*  But there has already been an immense wave of selling merely on fears of a catastrophe which may not - or at least may not yet - materialize.  

So while I fear something much nastier is waiting for us over the rainbow, for now the balance of risks has shifted decisively to the upside.  I'll therefore be using any residual weakness over coming days and weeks to liquidate remaining short positions and lightly establish longs.  As we near the minimum targets mentioned above, I'll begin to re-evaluate.  If I'm wrong, I'll eject on a sustained break below the 200-week moving average.

The bearish Three Peaks and a Domed House pattern I wrote up extensively in previous posts has delivered in spectacular fashion and remains in effect.  Despite falling an average 18% to date, the ultimate target for emerging market stock indicies (as represented by the ETF EEM
) is far below here.  But that doesn't mean these stocks can't enjoy a nice rally in the meantime.  

In fact if you missed the down move in EEM from April and want to participate, pray for a strong bounce here up to around 43.50, then consider establishing short positions in anticipation of a further 20%+ decline.