Has the Bottom Been Seen in the Dow?

Recent market action has led many investors to ask the question in our headline, "Has the bottom been seen on the Dow?" This question is a valid one and worthy of our attention. If this question can be answered in the affirmative, then we must abandon our bearish stance, admit our mistake in forecasting a major Dow decline and immediately exit all bearish market positions and enter bullish investment vehicles. If the question is answered in the negative, however, then we are completely justified in maintaining our bearish posture and staying where we are on the short side of the market. What follows is an in-depth analysis of where we are in the Dow Jones scheme of things and where we are likely heading.

Since the decision by the Federal Reserve on Oct. 15 to cut interest rates by an additional 25 basis points, the Dow Jones Industrials have enjoyed a spectacular, if not altogether shocking, rise to the 8600 level—a level unseen since August. Further, the Dow's impressive rise encompassed seven consecutive days of higher prices—a feat that hasn't been achieved in 16 months. The Dow's rise was also confirmed by the Transportations and was joined by upsurges in the NASDAQ, S&P 500, Value Line, Russell 2000 and Wilshire 5000 stock averages.

On the surface, all of these bullish developments present a sparkling picture and provides a certain justification for those who believe the market has seen a bottom and is headed to greater heights. What's more, bearish sentiment among analysts, advisers and investors—a reliable contrarian indicator—had been on the increase before the Dow's latest rise and now appears to have abated considerably, though investors still aren't quite as exuberant as they were at this time last year. The mass exodus of money from mutual funds also seems to have ceased and mutual funds are once again experiencing net inflows as investors pour money into stock funds in anticipation of the continuation of the bull market. Indeed, there seems to be an almost unanimous consensus—even from formerly bearish analysts—that the market has definitely turned around and is entering another phase of the bull market. One would almost be justified, based solely on the criterion of investor consensus, in joining this growing expanse of stock market bulls and jumping back into the market in a two-fisted stock-buying spree…were it not for certain technical and fundamental factors that we will now discuss.

While there are many useful methods of technical analysis, there are none quite so reliable as pattern recognition—the most important tool in our technical toolbox (as long-time readers of this commentary are aware). We proclaim an unswerving faith in the use of classical technical analysis (pattern recognition) over every other method of stock market forecast and analysis and have found its reliability unsurpassed by any other consideration, be it market "fundamentals," cycles, ratio analysis, etc. This point is being emphasized because it quite simply is the single most important element of market analysis. Without a thorough knowledge of chart patterns and their implications, an investor or analyst is doomed to an almost certain failure over the long run. We do not wish to be overly didactic and belabor the point but we find that this crucial truth is widely ignored in investment circles and has been the cause of much unnecessary financial loss. An understanding of classical technical analysis is what enables us to stand firm in our investment decisions—even when everyone else is doing the exact opposite—and gives us assurance in our market outlook.

That said, we move along in our examination of the Dow. The point we have emphasized over the past two weeks (perhaps to the point of monotony) is still very much valid. To summarize our position, we believe the bear market is still alive and well and is merely testing the resolve of the bears among investors while setting up the bulls for a cataclysmic fall. The Dow has, in our estimation, seen nothing more than a bear market correction—a bounce higher that has led many unsuspecting investors into the false notion that prices on the Dow will carry higher.

A number of technical measures support this view. For one, wave dynamics support our assumption that the Dow has merely "corrected" in its downward course, and further, this upward correction is rapidly expiring if it hasn't already done so. The bounce from Oct. 15 has developed in three "waves" in the form of an Elliott Wave "a-b-c" correction. This portends a definite continuation of the bear trend once this rise has been exhausted.

It would also seem that this latest upward thrust has retraced 62% of the previous decline from the Dow's all-time high of 9346—a Fibonacci ratio confirmation of a completed correction. If this assessment is correct, we can literally expect the Dow to re-commence falling anytime now.

The bearish "inverted triangle" pattern we have pointed out in the Dow over the last two weeks is still valid and in place. We quoted last week from Schabacker concerning the bearish implications of this pattern. We quote again from another source, Technical Analysis of Stock Trends, by Edwards & Magee, who describe for us the characteristics of this formation:

"[The inverted triangle] may be said to suggest a market lacking intelligent sponsorship and out of control—a situation, usually, in which the 'public' is excitedly committed and which is being whipped around by wild rumors…we have come to the conclusion that they are definitely bearish in purport—that, while further advance in price is not ruled out, the situation is, nevertheless, approaching a dangerous stage."

The Dow Jones Industrials futures chart (basis December) also shows a clearly-defined inverted triangle that has only slightly exceeded the upper boundary we drew for it last week. The pattern is still intact and it shows no sign so far of being violated.

More ominously, perhaps, the Dow Utilities registered a bearish key reversal two weeks ago and have begun, as far as we can tell, a bear market. This doesn't bode well for the broader indexes as the utilities are historically one of the more defensive sectors and have been used to hedge against bear markets.

We also note with interest that the stocks of major banks and financial brokerage firms have performed very poorly of late and this points quite clearly to coming bearishness in the overall stock market as well as the general economy.

Volume on the NYSE last week contracted almost everyday which is not a healthy sign for the bulls and could mean that this rally has reached the exhaustion point. It took tremendous volume to propel the Dow to these recent heights and most certainly will take considerable volume to allow it to attain still higher levels. So contracting volume is one sign that this is not the start of a new bull market.

Market breadth, while positive on some days, has more often than not been unimpressive as far as confirming a bull market. Breadth was negative at the close of Friday's session (Oct. 23) and was only moderately positive for most of last week. Again, this is another clue that we are seeing nothing more than a strong bear market rally—nothing more.

Finally, sentiment indicators, as measured by such tools as the ARMS index and CBOE put/call ratio, have been firmly bearish over the last week and point to further erosion in the broad market indices.

A superficial glance at the U.S. stock market at the present time might leave an investor with the impression that all is well on Wall Street and that Main Street is sure to prosper because of it. But a look at the market internals, accompanied by a thorough examination of technical and sentiment indicators, paints a bearish picture and provides a grim outlook for the remainder of 1998. In sum, the preponderance of evidence forces us to maintain our bearish posture. Until circumstances dictate otherwise, we remain firmly bearish.

As an interesting sidelight, we were intrigued by the signing of the peace agreement between Israel and Palestine on Friday. The signing by Israeli Prime Minister Benjamin Netanyahu and Palestinian President Yasser Arafat supposedly marks the beginning of a "new era" of peace and stability between these two neighboring (and hostile) factions. Whether or not the accord elicits the desired results is a matter of great speculation, but for our purposes, it provides the perfect signal for a top of this latest bear market rally. It has all the characteristics of a market "top" and smacks of the exuberant, bullish and (might we add) misleading psychology that is seen at every bull market top or bear market rally top. So from a socio-cultural perspective, perhaps this event alone provides us with all the evidence we need that this rally is just about spent.