It’s been a painful and frustrating year for equities. After a massive 7% rally to start the year, major averages peaked at the end of January and began their volatile descent. Four months later, we’re finally starting to see signs of stabilization.
Numerous geopolitical events have played a role in the price action we’ve seen over the past few months, but it has been the prospect of global trade wars that has stolen the show. Markets hate uncertainty, and trade wars are the epitome of uncertainty.
But lately the rhetoric has calmed down, and as I explained back in early March, we’re now starting to see the ZOPA (Zone of Possible Agreement) come into view. This is evidenced by the give and take we’re seeing play out with the China negotiations.
Recent talks over this past weekend have helped make it clear that both sides are interested in reaching an agreement. China has already agreed to increase its imports of U.S. products, and on Sunday, Treasury Secretary Steven Mnuchin went as far as to say that the U.S. is “putting the trade war on hold.”
That comment was later contradicted by U.S. Trade Representative Robert Lighthizer (perhaps some good cop, bad cop roleplay?), but at the end of the day, it appears that the U.S. will suspend the $150 billion that it had threatened to levy on Chinese imports.
The result has been very bullish action in the stock market, and that bullishness is taking major averages across some key thresholds. In fact, yesterday’s action signals that the short-term trend is once again bullish. Let’s walk through some charts of the major averages so you can see what I mean.
First, here is a look at the Industrials. I’ve annotated this chart quite heavily to demonstrate the shift that has occurred.
Source: Stockcharts.com. Past performance is no guarantee of future results. All indexes are unmanaged and cannot be invested into directly
Moving from left to right, we begin by noting the late-January peak above 26,500. From this point, the Industrials fell sharply and set a correction low on February 8th. The market rallied off that level, but then topped out near 25,750, setting a “lower high.” From there, the Industrials continued their decent, ultimately falling below the initial correction low from February 8th. This is labeled “lower low” in the chart, and is what provided us with one-half of a Dow Theory sell signal.
From the “lower low” set on March 23rd, the Industrials once again began to rally. This leg higher took the Industrials up to roughly 24,750, where they once again peaked and began heading lower. Note that this was, in effect, a third “lower low,” and this action was consistent with the bearish descending triangle pattern that we previously discussed.
But lo and behold, the Industrials were not fated to stay bearish for long, and this downward move halted near 23,800 – above the low set on March 23rd. This resulted in the industrials setting their first “higher low” in quite some time, which is often the first indication of a possible change in trend.
That shift in momentum was confirmed today as the Industrials climbed above their recent high to finally set their first “higher high” of 2018. In sum, the short-term trend in the Industrials is now bullish, and has been since the March 23rd low.
Now let’s take a look at the Transports.
You’ll notice here that the peaks and valleys tend to align well with the timing of the peaks and valleys in the Industrials, shown above. But the magnitude of the moves has differed substantially, and has led to a completely different chart pattern emerging here.
Source: Stockcharts.com. Past performance is no guarantee of future results. All indexes are unmanaged and cannot be invested into directly
Rather than turning outright bearish by setting a series of lower highs and lower lows, the Transports collapsed quickly and found themselves inside a well-defined trading range.
On April 9th, during the last five minutes of trading, the Transports did in fact close below the bottom line of the channel, effectively setting a lower-lower and confirming the bearish action in the Industrials. However, as previously explained, that move was so miniscule and fleeting that we chalked it up to noise.
In hindsight, that appears to have been the right call. The market has rallied since then, and as you can see, the Transports are finally breaking out of that channel to the upside. This move will carry more weight if it can be sustained over the next few days, but either way it’s a bullish sign and confirms what we’re seeing in the Industrials.
Next, let’s take a look at the action in two other key averages, the large-caps (S&P 500) and the small-caps (Russell 2000). Up first is the S&P.
Source: Stockcharts.com. Past performance is no guarantee of future results. All indexes are unmanaged and cannot be invested into directly
I’m not going to spend a lot of time describing this chart because, as you can see, it looks quite similar to the chart of the Industrials. The only major difference is that support held in late-March/early-April, so the S&P 500 never truly turned bearish. And now, as you can see, we’re back to a short-term pattern of higher highs and higher lows. Yippee.
Finally, the last chart we’re going to look at today is the small-cap Russell 2000 index. Small-cap firms are more insulated from the global economy, and they also tend to benefit from a stronger dollar. These factors have helped small caps outperform other major averages this year.
Source: Stockcharts.com. Past performance is no guarantee of future results. All indexes are unmanaged and cannot be invested into directly
Of all the charts we’ve looked at today, this one is the most bullish. Not only did the small-caps not set any “lower lows,” they never even went back to retest the February low. Instead, we’ve seen each subsequent leg down met with increased buying pressure, resulting in a series of higher lows.
That bullish action was capped off last week (and again this week) as the small-caps rose above their January peak to set multiple new all-time highs. There is nothing more bullish than that.
So there you have it – the market is once again bullish, at least in the short-term. This doesn’t necessarily mean the market’s going to move substantially higher anytime soon, but it should quell some of your concerns that the primary trend of the market has shifted. This may also present a decent entry point for those who have been waiting for an opportunity to add to their positions.
Before signing off, I’d like to briefly touch on a related topic. In the charts above, and in much of my commentary over the years, I’ve tended to simplify more complex chart patterns (head-and shoulder-tops, triangles etc.) into the notion of “higher or lower highs” and “higher or lower lows.”
This may confuse some of you, but this is technical analysis distilled to its simplest form. It’s like the least common denominator for chart patterns. Here’s what I mean.
A typical head-and-shoulders top, which indicates a reversal from a bullish trend to a bearish one, looks like this (chart courtesy of Wikipedia).
But what’s really happening here? If you notice, the action in this chart can be broken down into a transition from higher highs and higher lows, to lower highs and lower lows. Like this:
Here, the “lower low” would be triggered immediately when prices on the right side of the chart drop below the neckline. That’s when we officially shift into a bearish trend – defined by lower highs AND lower lows – and it’s also when technical analysts would suggest you sell based on this chart pattern (when the price drops below the neckline after completing the right shoulder).
Make sense? When we view market action in this simplified form, it makes it much easier to determine the inherent trend. If we look at price action this way, we’re not left asking ourselves questions like: “Well, the right should is higher than the left, does that mean this is really a head-and-shoulders pattern?” or “Hmm … the neckline is off-kilter, how does that affect the probabilities associated with this type of pattern?”
Using the concept of higher highs, lower lows, etc., we know very quickly and without question the direction of the underlying trend.
The preceding content was an excerpt from Dow Theory Letters. To receive their daily updates and research, click here to subscribe. Matt is also the Chief Investment Strategist at Model Investing. For more information about algorithmic based portfolio management, click here.
