Dow "correction" Long Overdue

After spending most of October and November in a relentless runup, the Dow Jones Industrials may finally be losing steam. Certainly, a correction is long overdue and our technical indicators point to at least the 8400-8650 area as the most likely area for a near-term retracement.

The "ascending wedge" pattern we've followed in the Dow's chart for the past several weeks has finally been broken to the downside. For the past week, the Dow has been down as much as 400 points from its all-time record of 9377 achieved last week.

From a chart perspective, it looks like a double top may have already formed in the DJI. While several major components of the Dow still look bullish (if toppy) the Dow itself may finally have exhausted itself. One thing we have learned over the past three months, however, is to "never say never" when it comes to analyzing the stock market during the blow-off phase of a mania. So it would not surprise us if, once again, the Dow blew right through a seemingly insurmountable resistance zone. If there is one constant during this turbulent, chaotic market environment it is "expect the unexpected" and be ready for anything to happen. That is the best advice we can give right now.

The Dow Jones Transportation index, after a decline early in the week, bounced back strongly in what looked like an attempt to once again break the crucial 3100 resistance level. This level we view as important because it represents the 62% retracement level from the October low in the Transports (in Fibonacci ratio analysis, the 62% retracement area is one normally associated with bear market corrections and is normally the highest level to which prices will travel before resuming their previous course). Thus, 3100 must hold in the Transports in order for the bear market scenario to remain valid. If this level holds, it will signal an important Dow Theory non-confirmation and would mean a top is in, even if the Dow Industrials power to higher levels for the next few days. Any upside penetration of DJT 3100 likely means a move to the 3600 all-time high and would provide bullish confirmation for the Dow Industrials. So 3100 holding as overhead resistance in the Transports is the first indication a top may be in for the U.S. stock market (though it may be a while in coming for the Industrials). Small-cap stock indices failing to reach previous all-time high levels is another important clue this is nothing more than a bear market rally. However, the latest corrective action in the Dow has been typical of corrections that precede further highs. Consider: the decline in the Dow has been very steady and controlled. No one has come close to panicking and the sell-off has never threatened to get out of hand. Also, internal strength measurements such as the advance/decline ratio is only somewhat negative and the ratio of new highs/lows is actually positive. While the number of NYSE issues achieving new highs is nowhere near its summer bull market proportions of nearly 300, it still has remained positive throughout the upmove that began in early October. Thus, a bullish near-term stance in the Industrials is still warranted until the technical indicators tell us otherwise.

The NASDAQ advance/decline ratio tells a different story, however. The ratio of new highs/lows, while positive on the NYSE, has been negative on NASDAQ of late. Keep in mind, NASDAQ has been up strongly throughout this rally and has frequently led the way for other indices. Most of these gains, however, were powered by the explosive upward moves in Internet stocks like Yahoo! and Microsoft. What does all of this mean? It means we are in a stratospheric bubble market being propelled by nothing more substantial than the hot air of "expected future returns." Most of the leading stocks have shown negative earnings over the past several earnings seasons. Bottom line: we are at a market top, and while it is possible we may have already gone over the edge, we should be prepared for at least a few more weeks of bullish behavior in the major blue chip stocks as well as indexes like DJI and NASDAQ.

This interpretation, which we are forced to cling to until our charts tell us otherwise. However, we have definitely entered some sort of corrective pattern as the bearish ascending wedge pattern we have followed in the Dow Jones Industrials for several weeks now has been broken to the downside which technically confirms the beginning of a correction. Under the rules of classical technical analysis, the Dow should drop to at least the base of the wedge at the 8400 level. Further, this level represents (approximately) the Fibonacci .50% retracement level. The Fibonacci .618% retracement level is 8202 and the .38% retracement level is at 8646. So we should at least see a move to 8646 if this is truly the beginning of a corrective move. If the Dow moves higher and makes another run at the all-time high of 9377, and especially if the Transports break above 3100, you may safely disregard this entire analysis as it will mean the bull is still very much alive and has intentions of taking the Dow to the 9600 level.

It is no secret now that the U.S. economy is slowing down. Economists and other financial analysts across the country and around the world are talking about it. Even mainstream news outlets—including such magazines as Forbes, Newsweek, The Economist, and Business Week—are giving the subject top priority in almost every issue. This fact alone confirms the eroding U.S. economic infrastructure and proves we are indeed heading into a major slowdown.

While it may be tempting to take a contrarian stance and assume this massive coverage only proves the opposite—that the economy is not slowing down—it must be pointed out that this contrarian indicator of the mainstream media applies only to the stock market, not the economy in general (which is much broader and more complex than the equities market).

When a broad section of the country begins to recognize the dangers posed to our economy due to our exposure to foreign countries with economic problems of their own, growing deflation, rising corporate layoffs, etc., it confirms that there really is a problem and that the problem will only continue to expand with growing realization (and indeed, will worsen when the inevitable overreaction develops on the part of the average citizen and politician).

And when we examine this rapidly eroding economic infrastructure what do we find? A flood of cheap imports from a storm-tossed Asia, thereby producing a massive trade deficit; an unprecedented number of corporate layoffs; growing corporate debt and rising personal bankruptcies; a diminished business outlook due to the decreasing demand for many services (exacerbated by the fact we are a service economy); a potential bank crisis; a farm crisis; and the spreading winds of commodities deflation.

On the deflationary front, we find that three of our biggest leading indicators—the price of copper, steel and crude oil (all measures of basic economic demand)—have now reached multi-decade lows. The CRB commodity index itself, which measures the demand for a broad basket of commodities, is now resting at crucial chart support of $200. If this support is broken, watch out below—the next chart support level is not for a long way down. If this happens, it will be the first major sign that a deflationary tidal wave has reached our shores, and it will only be a matter of time before the few remaining strong sectors of the economy get washed out. In many ways, a collapse of commodity prices is worse than a stock market collapse.

Well, it's official. For the first time since 1929, every living person in the United States of America has an opinion on where the Dow is going. And the diversity of market opinion, much like the diversity of individuals in the U.S., is endless. It seems that no matter where you go there is someone offering advice or opinions on what the Dow will do from here. It has become so extreme lately that one can hardly hear oneself think over the cacophony of conflicting market opinion.

In the last two weeks alone we have noticed a considerable increase in this broad diversity and ubiquity of opinion. Some believe the bull is back with a vengeance and is here to stay. Others believe we have entered a long period of consolidation that will witness a net sideways pattern in the Dow for the next few months-to-years. Still others (ourselves included) are of a bearish persuasion, though to varying degrees, and believe a bear market accompanied by either a major sell-off or outright collapse is imminent. So which group is correct? May we offer that it doesn't really matter whose outlook is closest to being true at this point?

The most noteworthy point of this catholicity of market opinion is not what one group thinks or the other, or what the majority believe. Its broad significance is that speculative activity has become rampant and is so widespread that almost no single group or individual is left untouched by it. Our individual and collective fortunes have become so inextricably linked to the Dow's performance that its very performance has become an obsessive mania—a common passion—that has become so big and fascinating that it has relegated every other important national endeavor to relative obscurity. Religion, politics, military questions—all of these have taken the proverbial backseat to the Dow and have in large measure been completely obliterated from the national psyche. When this happens, speculative activity has reached a climax and is destined to implode of its own weight.

How can we be certain speculative activity has reached a peak? When speculation consists not only of actual financial dealings but of merely "speculating" on the Dow's performance, whether one is in the market or not, speculation has gone too far. The Dow has now become a common obsession in the U.S. and has truly replaced baseball as the national pastime. This alone provides all the clue one needs to determine a market peak. We have now arrived at that peak, even if the Dow continues to travel a bit beyond it in blow-off fashion.

Our advice: unless you can truly afford to speculate (bearing in mind all of its attendant risk for potentially limitless losses), sell now while you still can, extinguish all unnecessary debts and make sure you have a bountiful supply of cash.