By Michael Kahn, Barron's | 3 December 2008
While still a risky proposition, the case for a short-term market upswing is starting to build. It just may be a decent holiday season for the stock market despite the ongoing problems facing the economy. Even though it was just two days ago that the Dow Jones Industrial Average suffered a decline of 680 points, it's fourth-largest point decline in history, it's clear that a number of positives are building.
My favorite analogy is that a market forecaster operates very much like a trial lawyer in court. Aside from any theatrics either may employ, both seek to build a case piece-by-piece until the evidence points towards a conclusion. For investors, that conclusion is buy, sell or hold.
To be sure, we've had several exciting, but quick, "short covering" rallies over the past two months. Bears who held short positions decided to take their profits. It incites a stampede of buying. But without a true change in the supply and demand picture, it cannot and does not last for long.
However, over the past two weeks, we have seen three occasions where buying was more than simple covering of short positions. While volume was not impressive, the trading activity that did occur had an element of broad-based intensity that is not seen very often. And since the market was rather washed out already, these instances of surging buying interest suggest that there is a segment of market participants that are just itching to get back in. I interpret that as demand.
Critics will point out that such interest in the market means that it has not suffered its final capitulation where the last stalwart bulls finally give up, but that is an incorrect assessment. We have seen quite a few days of such "get me out of stocks" selling behavior, most notably the several days of disgorgement leading into the October 10 low and again at the October 27 low. This pair of conditions— the washing out of the market and renewed interest— is a positive for the market and we should put it on the bullish side of the ledger. It is not enough to declare it time to buy but, again, we are still crafting the case to do so and are not quite done.
Another positive comes from simple chart reading and momentum analysis. Last week, I pointed out that the major market indexes had formed patterns called "falling wedges," a bit of jargon for a declining trend that has lost its downside power (See Getting Technical, A Thanksgiving Deferred?, November 26). This week, the indexes are threatening to break out to the upside from their respective wedge patterns. For example, the Standard & Poor's 500 tested the top border of its pattern last Friday and despite Monday's monster decline it is once again knocking on the door to that breakout (see Chart 1).
Chart 1
One of the observations I have made over a 22-year career looking at charts is that strong markets tend to hover near resistance features— the upper border of the wedge, in this case. Weak markets tend to fall away from resistance quickly after touching it. The latter was the case on Election Day, and the index fell hard after touching the upper border of the still-forming pattern.
Momentum readings, such as the MACD (moving average convergence divergence) shown in the chart, have also been climbing from low levels even though prices had been setting lower lows. This divergence between the two tells us that the urgency to sell has abated— another sign of a shift from bear to bull. Again, neither of these conditions, the firmness of the index within the wedge pattern and the momentum divergence, is a green light to buy, but let's add both to the bullish side of the ledger.
Ian Woodward, market guru at High Growth Stock Investor software, said, "There is no silver bullet," referring to each indicator chart watchers use. "But two lead bullets are better than none and four are better than two," he added. That means that the more different types of indicators we can add to the bullish side, the more likely the market will reward us with a rally.
We can add continued gloomy sentiment of investors and a somewhat calmer volatility index (VIX) to the above to create a decent case for a short-term rally. It's still a risky argument but it is the best one I've seen in many, many months.
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Normxxx
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