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High bullish sentiment; finishing Dow Theory (3)

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I notice that you trader sentiment indicator shows a high degree of bullishness and you discussed this as may be bearish. How so? And how does this stack up against how you see the OEX chart? thanks

In terms of technical patterns and such, the S&P 100 (OEX) is not out of the woods in terms of a clear-cut breakout above resistance. The index got right to the below-highlighted trendline on Tues (7/12) and today (Wed) traded just at and under this trendline. The red down arrow on the OEX chart below shows this 'theoretical' resistance at the down trendline relative to the early-March top.

Of course this most recent rally, again over 4 strong days like before, has been led by the broader market; e.g., the S&P 500, the un-weighted S&P 500, the Russell 2000, and so on.

As far as my 'sentiment' indicator goes, it has recently shown a bullish extreme, above what has been seen since the December high. The two similar extremes are highlighted on the chart above by the yellow circles. The prior (Dec.) example of a similar high bullishness led to a tradable downswing, but the RSI then was also then registering an 'overbought' extreme; not true yet in this recent advance.

The bullish extreme in my sentiment indicator was quite far ahead of the top in early-March and therefore not useful just in and of itself (as a sell 'signal').

When bullishness gets very pronounced and for days or weeks, it is often the sign of a stronger than usual advance ahead; what could call a trend 'leg'. The lag time between such high 'sentiment' readings then also grows LONGER. If this pattern is being repeated here, then OEX will go on to new high above 585, before coming down in a significant way.

I also note that this indicator, or any other, shouldn't be relied on alone, no matter how good it is and this one is very good indeed. However, only if the trend/price pattern started to suggest a top, would I then give more attention to the high bullishness (such as seen on my 'sentiment' indicator above), and consider trading against the existing trend; e.g., by buying puts in what has been an uptrend.

I mentioned that the broader market indices like the S&P 500 (SPX) have been providing the lead in this current rally phase. Here's the weekly SPX chart below. The breakout above its long-term trendline was significant.

The 'validity' of the bullish breakout seen in the below highlighted (down) trendline, was tested by the pullback to the trendline. The rebound FROM it was suggesting a longer-term trend breakout or change in direction to up.

I'm talking about the MAJOR trend and some would say that the major trend went from down to up by mid-2003. More on that when I complete my little past 3 week chat in this space (the Trader's Corner) on Charles Dow's market observations and 'theory'.

Before I get into Dow's classification of the different trends or different STRENGTH and DURATION of trends, another OI Subscriber question to me was how useful or relevant is the Dow Industrial (INDU) Average in our current market.

Well, when the Dow 30 LEADS a market advance, in a 'solitary walk of the Dow', it's an indication that the rally may not have enough buying power to keep the broader market afloat. You can then be alert to S&P and Nasdaq tops, and be ready to buy puts.

When INDU goes to a new high or low, but the related Dow Jones Transportation (TRAN) does NOT follow suit, this has proved to give useful info or insight into the market trend. Both should go to new highs or lows to 'confirm' the major trend. Looking at the INDIVIDUAL charts of ALL the 30 stocks in INDU is far easier than looking at all 100 of S&P 100 stocks, or just the biggest companies in that index, since it is capitalization weighted.

I studied ALL 30 Dow stock charts today, as surveying all can provide insight into whether the Dow will break out ABOVE the down trendline. Or, even to below it.

Of the 30 Dow stocks, I rank 19 as having neutral to bearish trends, 8 as having bullish trends and 2 charts in transition from bearish to possibly bullish. The other noteworthy thing is that most have stopped going down. So, the potential is there, if about 5-6 more Dow stocks got enough buying to lift them.

The Dow Transports (TRAN) have broken out above its down trendline, so may be 'leading' INDU here. In either case, both averages have to surmount and go above their prior highs as noted by the dashed horizontal lines and the red down arrows on the two charts in one above.

All in all, whenever I think the Dow Industrial average is not worth tracking as closely as the other major indexes, I take a risk that the INDU chart is not going to tip me off to something coming up; e.g., significant potential for a reversal.

The very-regular symmetrical triangle being traced out by INDU as highlighted in the above chart, shows (perhaps better than the other indices) that buying and selling forces my be poised to go strongly in one direction or the other; one side is 'ready' to overwhelm the other. There's potential for a sizable further advance, based on the upside possibilities for around 2/3rds of the Dow stocks, even if they have a limited 'oversold' rebound.

The prior Charles Dow/Dow Theory articles I mentioned can be seen online by clicking here for the first article and here for the second Dow theory article.

I wrote last week on how Dow brilliantly observed way back, and which is still true today, that trend PHASES go from 'accumulation' by savvy insider type buyers to more and more participation by the investing 'public', as in directly buying/selling stocks, to 'distribution' of the same stocks accumulated earlier (by the pros to the public).

At the end of this phase, eventually we get to 'panic' selling. This sets up the market again for a new phase, after however many months or years, for a new period of accumulation of undervalued stocks, once key insiders start sensing an better earnings trend ahead.

Dow also created the defining category of what are the TYPES of trends.

Just as the market tends to have three phases related to mood or market sentiment, market trends can be divided into three types. The most important to investors, those who look to buy and hold stocks for as long as a stock is tending to command an increasing price over time is the 'primary' or major trend.

The primary trend is one lasting a year or more up to several years. There are counter movements in the direction of the major trend and these trends in the opposite direction, Dow called secondary price movements. It is still somewhat unclear whether the MAJOR market trend is now up. It seems it may be; investors are increasing acting like it is.

Secondary trends develop after bullish or bearish expectations for the market get overly one-sided and ahead of the fundamentals related to earnings prospects. Eventually a 'reaction' develops that causes prices to correct back to a more realistic price level. Reactions or corrections are price swings that are in the opposite direction of the main or major trend. Once these run its course, the primary trend resumes.

The segments that make up the price swings that are both in, and against, the direction of the primary trend can also be referred to as intermediate price swings or moves when they last a few weeks to a few months only. The intermediate trend is of keen interest to those trading stock and index options.

Within these intermediate price moves are day-to-day price fluctuations that Dow called minor trends. These can be a few hours to a day or a few days theyre most often contained within a week period. The minor trend is of even more significance to option traders; if, for nothing else, then 'timing' put or call entry when the short-term trend turns in the SAME direction as the intermediate term trend.

Both intermediate and minor trends are of importance to traders primarily minor trends are all that concern a day trader who will likely complete every trade within the same day. Intermediate trends are of importance to investors when they are looking for the best point to enter the primary trend or to add to their position(s) in a stock or go more heavily into stocks.

The primary trend is composed of smaller movements of an 'intermediate' duration of a few weeks to a few months. These intermediate trends run counter to AND in the same direction as the primary trend - they can also send prices into a sideways movement. Intermediate trends are also called secondary trends.

An essential guideline as to a trend being a primary bull market is that each advance within the advancing trend should reach a higher level than the rally that preceded it. And, each reaction or counter-trend move should stop at a level that is above the prior major downswing. The reverse would need to hold true to be considered a primary bear market trend.

An analogy to the primary trend is that it is like the tide of the ocean. In the rising tide, each wave comes in to a higher and higher point. And, just as the rising tide lifts all the boats, a bull market takes all stocks higher. The waves in an outgoing tide gradually recede away from a high point and all boats fall with it.

A primary up trend is considered to be a bull market and primary down trend, a bear market according to Dow. If you are an investor in terms of your time horizon and investment goals, you should attempt to buy stocks as soon as possible after a bull market has begun.

An example of a prior shift in the major trend in terms of an EXAMPLE only is shown in the chart below, taken from the 1990 1991 period, showing both a primary down trend or bear market and the primary up trend or bull market that developed following it

You will notice from this period shown in the above chart that the duration of the primary bear market trends were relatively short compared to the duration of the primary uptrends. On average this has been true since the 1950s due to the longer periods of economic expansion and shorter periods of recession there is more urgency to end a recession.

The last bear market can be said to have ended at least by mid-2003. That major down trend was about 2 and half years. But, compare this to the multiyear bull market that preceded it; e.g., from about 1994 to 2000; or, taking an even longer view of an overall bull market existing from around 1982 to 2000 (discounting the 87 crash as it was so short-lived).

This fact of the relative duration of bull and bear markets also relates to the fact that investors tend to stagger their purchases over the duration of bull markets, providing ongoing buying power, whereas selling out is often closer to being a one, two or three time decision; also, would be buyers stay away and dont tend to 'support' the market on the declines, especially in a panic phase.

The secondary trends are of shorter duration: typically, 3 weeks to 3 months interrupt the major direction of stock prices with a countertrend movement. Called 'corrections' in a bull market, as they 'correct' a situation where prices have risen too far, too fast. In a bear market, countertrend rallies can be considered and are often called, 'recovery' rallies.

Frequently, these secondary countertrends retrace anywhere from a little over a third to as much as 2/3rds of the prior advance or decline. Very common is to see retracements of 50% of the prior price swing that was in the direction of the primary trend. It is not always easy to decide when and if a secondary trend is underway, but there are technical analysis tools that will help
us tell.

To continue an ocean analogy, if the Primary trend is like the TIDE, the secondary trend is like the WAVES of the ocean. They can be big and they can knock you over, but they will come in and go out within the bigger movement of the tide the major or primary trend.

The minor trends are the price fluctuations that occur from day to day and week to week according to Dow. A minor trend will rarely last more than 2-3 weeks. In terms of the overall market trend minor trends are 'noise' so to speak; and, are relatively unimportant. They can be compared to the RIPPLES on a wave the secondary trend. Together, the minor trends make up the intermediate trends.

Lastly, we could say that the minor trend could be one that is set off by the actions or words of an individual for example, the chairman of the Fed when that individual makes a statement hinting at the direction of policy regarding Fed bias toward raising or lowering of interest rates. Or, the precipitating action might be a statement from a key company in a key industry about their actual or expected earnings or profit trends.

Last, but not least is the theory of 'confirmation' and 'divergence' of Charles Dow, already discussed in the prior articles I referred you to. Based on this concept of Dow's came all that followed, where technical INDICATORS (e.g., RSI) are seen to be 'confirming' or not confirming PRICE moves to new highs or lows.

Also, the way that volume is seen as confirming the price trend or diverging from it if so, a clear warning sign. Dow indicated that volume was a 'secondary' indicator to PRICE but it was important to watch as a confirming aspect.

On balance, Charles Dow made a huge contribution to the understanding of market behavior; or, 'human' behavior as it manifests in trading and investing in stocks. I still benefit from re-reading his main principles of market behavior from time to time.

Good Trading Success!

Please send any technical and Index-related questions for possible use in my next Trader's Corner article to Contact Support with 'Leigh Stevens' in the Subject line.

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