Will History Repeat?
For the last few months, the possibility of war has been blamed for the market's big drop. However, anyone watching only the charts would have pegged a move right to these levels. I'm not suggesting we ignore the environment in which we are trading, but it is interesting just how reliable the technical indicators have been.
I'm looking at the head and shoulders patterns that have formed over the past few months in the Dow, OEX and SPX in particular. It may have taken the specter of war to get us there, but the breakdowns over the past few sessions mirrored those that we saw over the summer-fall session. Not only did the Dow fulfill its objective, as it did in October, but so did the SPX and OEX (more on these objectives later). A look at the daily charts completes the picture that I've been drawing over the past couple of months and leaves us wondering if it's time to call a bottom, or jump on short for a further breakdown. Certainly we see no signs that would indicate a possible reversal, with not only the U.S. testing multi-month lows, but also European markets sinking hard. The FTSE dropped 4.8%, the DAX fell 4.4%. When the market plague is spreading across the globe, it is hard to find any reason to step in long. However, we did see a big bounce after fulfilling those objectives in the U.S. markets and bulls will point to history (as far back as October, at least) as a possible indicator that it is time for a rally.
Chart of the Dow
We continue to hear that the possibility of war is what drove the recent collapse. But we have known the U.S. was planning an Iraqi invasion ever since last summer. How then do we explain the rallies of last fall and early January? The easy explanation is that last fall we got a number of earnings releases that, while seemingly awful, weren't as bad as some had predicted. That led to a reallocation between bonds and stocks that gave the market a boost. Once we got into the retail season and saw signs of further weakness in consumer spending, it was back down again until the end of the year. Then came the fund money. Those investors funding their retirement plans and brokerage accounts at the beginning of each year were apparently the impetus for the beginning of the year rally for the first couple of weeks, as was the President's announcement that his stimulus plan would seek to eliminate the tax on dividends. That would have amounted to a fundamental change in the value of dividend paying stocks and gave the bulls an excuse to step back in. However, the rally failed once again, forming a nice right shoulder to the head and shoulders pattern we saw market wide. The failure came as companies beat fourth quarter expectations with January and February earnings releases, but painted a grim picture for the rest of the year. We saw numerous lowered expectations and heard many cautious statements. That turned attention back on the economy and with war closer and fuel prices higher, there was a snow ball effect.
We continue to get daily doses of international developments and although we can spin them as bullish or bearish for the market, the overall trend has remained down. That indicates that even developments that seem to delay the war, such as Britain's new set of conditions for Iraq, can't seem to give the market a boost. Most analysts simply say the market hates uncertainty and once we know whether we will attack and when, we'll finally get a rebound. Another school of thought says that Britain's new proposal suggests a split with the U.S. that indicates the U.S. will be heading in alone. That could be bad for the U.S. markets, as foreign investors pull money out of dollar denominated stocks.
While the war fears have remained consistent, the price of oil has continued to climb as the timetable grows closer. While we have yet to approach the spike to $40 per barrel in the crude oil futures that was achieved on February 27, we have maintained much of the recent gains, with the futures still holding over $37. That is a far cry from 2002's top right around $30. As fuel prices remain high, business costs do as well. In spite of OEPC and Saudi Arabia's comments this week that they would make up for any shortfall in the world oil supply in the case of war, anyone who has filled up a car with gas recently is feeling the same pinch as many businesses. We are already in a world of weak business spending and the price of fuel continues to cut further into the bottom line. This can be seen especially in the Dow Transports. Traditional Dow Theory relies on this average to confirm moves in the Dow Industrials and so far we are seeing new multi-year lows in that average. When it bounced from its October low on February 25, it appeared we may have seen a short- term bottom. However, that bounce was short lived and not only have we rolled back over below that October low, but also took out the September 2001 low on an intraday basis this morning. That low followed the 9/11 attacks and cut the price of many airline stocks in half. The Transports seem to be signaling another shot at the October lows in the Industrials, which would give us another 200 points of downside, at least. However, today's bounce back above that September 2001 low and into positive territory by the close may also signal that we finally reached at least a temporary floor, as we bounced from a significant level. At the very least, it signals a confluence of important levels tested across the board today.
Another 200 points of downside may be wishful thinking for shorts, but there is little argument that the trend is on their side. There is little horizontal support on the bar charts to indicate any point at which we might bounce now that we have taken out the 7500 level intraday. Not only was that the July low, it was also the head and shoulders objective and the point and figure target on the Dow Diamonds (75.00). The head and shoulders objectives I referred to earlier are just below 400 in the OEX; just under 790 in the SPX and 7500 in the Dow. Those objectives were hit almost to the point in the OEX and SPX, with lows of SPX 788.90 and OEX 400.24. The fact that the Dow fell below its H&S objective this morning can be seen one of two ways when comparing it to the SPX and OEX. Bears will view it as signaling further weakness and as the first domino to fall ahead of the others. Bulls will cite the reversal after the objectives were matched, similar to October's action, as well as the higher number of stocks in the OEX and SPX and the ability to trade futures on the SPX as signs that they are more representative of true sentiment. If the bulls were able to defend those broader averages, then maybe we should be weighing the action there more heavily than the break below 7500 in the Dow. Remember that the Dow did not close below that H&S objective. Also note the fact that the Dow underperformed the others in October, hitting its H&S objective while the others bounced just above theirs. That would be similar to relative levels we see now if we rally from here.
Chart of the OEX
Chart of the SPX
Chart of Crude Oil Futures
Those point and figure charts are showing us some signals that actually favor the bulls at this point. Now that we have fulfilled the head and shoulders objectives in the broad market indices, we are also seeing the bullish percents across the board in oversold conditions. 30% is considered oversold and the current readings are Dow 10% SPX 30% and OEX 24%. These bullish percents measure the number of stocks in an index that are currently giving buy signals on the point and figure charts. The Dow saw its bullish percent sink as low as 4% in July and 8% in October. Those extended percents both signaled a coming rebound. The current reading of 10% would indicate a similar extension and when combined with the achievement of the 75.00 target on the Diamonds, which are based on the Dow, we see a shift of risk less in favor of the bears. The OEX is also bounced just 10 points away from its target at 390. The SPX target is 785, which we came just points 3.90 points away from achieving, as well. The SPX, however, derives its count from the current column it is working on to the downside and if it does trade 785 on this drop, the count is extended lower to 775 (and 10 additional points for each five it falls until a rebound of 15 points).
Certainly none of these indicators is an absolute target. Each of the indices is made up of numerous stocks. However, there are plenty of technicians and institutions watching these patterns and they tend to become a self-fulfilling prophecy. If you were going to pick a bottom, the completions of a number of head and shoulders patterns, combined with extended, oversold bullish percents might not be a bad place to do it. Therefore, we tend to get some nibbling from the long side when we achieve those targets. The last time we achieved the Dow target, we got a massive reversal the same day. While we did end the day in the green, registering a reversal of 140 points intraday, it still does not measure up to the bounces we got in July or October off the bottoms. However, the fact that they successfully defended the OEX and SPX head and shoulders fulfillments could still be signaling at least a short-term bounce. Certainly if history were to repeat itself, a rally from these levels would fit the pattern. How far that takes us is still anyone's guess and in a weak economic environment, it may be just another shorting opportunity.
Another indicator that has been reliable in the recent past has been the Market Volatility Index (VIX). The VIX has been range bound between 34-35% and 40-41% for the past couple of months, with moves to those levels signaling at least short-term reversals in the equity markets. The VIX, which measures option premiums in the OEX, generally increases as the market drops and traders are more leery of selling puts and decreases on the way up as the fear abates. The upper end of that range has been between 40-41% intraday, with each foray over 50% eventually ending in a market bounce and a close below that level. The 40% mark was hit again today for the first time since February 13, and voila! - a market bounce. We traded as high as 41.16% intraday, but finished the day at 38.99%. Traders should have this measure on their screens and exercise caution with current positions think about tightening stops as we approach either end of the range.
If traders are looking for a pocket of strength in stocks, they should look no further than the formerly beleaguered Semiconductor Stocks. This sector led the way down in 2002 and again in late January. However, it stayed in the green for most of the day and finished with a 3% gain. While its hard to peg just why these stocks are hanging in there, they have held support at 280 ever since making a failed run at 300 a couple of weeks ago. For those traders taking clues from this sector, it gave a good indication that the early sell-off was doomed.
The Nasdaq Composite staged an equally impressive rally. After closing at new relative lows on Tuesday, it continued down past its Feb 13 bounce level at 1261 and looked as though it was on its way to a test of 1200. However, after bottoming at 1253, it followed the Dow, SPX and OEX to a close up 7 points, finishing on its highs of the day.
Financials got yet another dose of the ongoing credit problems. It all started last year when J.P. Morgan suffered losses due to growing problems with underperforming debt in the telecom industry. Those problems have extended to almost every area of business, and also to consumers. Morgan Stanley was downgraded today by Wachovia, which lowered its estimates for 2003 and 2004 due to weakening consumer credit trends which could lead to a higher credit card charge-off scenario.
Chart of the VIX
So what did we see today? We saw some downside objectives filled and a big bounce afterward. It wasn't the same type of major reversal off the lows we saw in July and October, but it was still an impressive defense by the bulls. The trend remains down, and the world markets are still setting new lows. However, with oversold bullish percents, a VIX reading at the top of its range and a recent drop of more than 1300 Dow points from the January highs, the risks certainly seem to be shifting. I'm not going to declare the end of the drop, but if there were ever a time for the bears to start worrying and tightening their stops, this is it.