(This is an excerpt from Friday's blog for Decision Point subscribers.)
This week I wrote the following article for the Learning Center in response to a question from a subscriber.
We use the relationship of the 50-EMA and 200-EMA to define bull and bear markets. When the 50-EMA is above the 200-EMA, we consider the market to be in a long-term bull phase, and vice versa. This is an important definition because we will want to bias our medium-term analysis in favor of the long-term trend. As a reminder, we will often state that, "Bull (or Bear) market rules apply." In the general sense, this means that ambiguous medium-term situations will most likely resolve in the direction of the bull or bear phase, so we should perform our analysis and draw our conclusions with that in mind.
More specifically, let's look at the common occasion when the market is overbought or oversold. In a bull market oversold conditions are seen as a buying opportunity and will usually result in a rally to relieve the condition. When a bull market becomes overbought, it is not usually cause for concern, because corrections from these conditions are often small, and sometimes the market will continue to rally, while the overbought conditions are relieved internally.
The opposite is true with bear markets. Overbought conditions are most often a setup for a new down leg, while oversold conditions should be considered as being "thin ice," not a solid base of compression from which a rally will emerge. For example, buying into bear market declines is a dangerous practice.
Chart formations are another area where the long-term market bias should be considered. For example, a bearish head and shoulders pattern in a bull market is less likely to execute by violating the neckline, or, if it does execute, the decline may abort into an upside reversal before price reaches the minimum downside target. The same would be true of a bullish reverse head and shoulders in a bear market.
As you have no doubt concluded, the bull/bear bias that we apply to our analysis is a purely subjective judgment, albeit based on a purely objective EMA crossover. Further, the amount of confidence we have in the long-term bull/bear signal should be influenced by whether the 50/200-EMAs are converging or diverging. When the EMAs are diverging, it means that price is in front of both EMAs and they are confirming the strength of the move. When the EMAs are converging, it means that price is either between the EMAs or is running behind them. In either case, converging EMAs are a sign that price is performing in a direction opposite of the crossover signal.
Bottom Line: We should temper our expectations of technical information based upon the long-term trend of the market. In a bull market, expect bullish outcomes. In a bear market, expect bearish outcomes.
This brings us to the present and begs the question of what rules should we be using now? On the chart below, we can see that the last 50/200-EMA crossover generated a long-term buy signal on 8/11/2009, so in the broadest context bull market rules apply. However, the 50- and 200-EMAs have been converging for a few months, and the price index is below them, so on a scale of zero to 100 (100 being strongest), I'd have to say that my bull market confidence level is about 60.
Even though my confidence level is getting low because of the convergence, it doesn't mean that a 50-200-EMA downside crossover is going to happen. Convergences happen (see the one in June 2008), and we have to ride them to their eventual resolution. That is not to say we would be holding stocks based solely on the long-term signal. The long-term signal is intended to provide a bull/bear market context within which we perform our analysis and draw conclusions. Our current medium-term market posture is still neutral based upon the Thrust/Trend Model.
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Technical analysis is a windsock, not a crystal ball.
