The action over the second week of October satisfies an expectation we have had for the year 2006: A fresh all-time high. The move into new-high territory was not an easy breakout. In May, the Dow crept to within 90 points of an all-time high and, thereafter, sold off to lose 8 percent of its value throughout the next couple of months -- this was one of the strongest pullbacks the market had since the major low in 2002.
In July, the market found its footing and once again made a second run for its all-time high. It has been all-up ever since. Here's a toast to the bulls for a well earned victory! As of October, it was back to work.
In the third week of October, we had the Dow trading at a new all-time high, and the popular question seemed to be "where is the next resistance?"
When a market is hitting an all-time high, looking for the next order of resistance or a target point is usually very tough. Needless to say, because it is literally in "uncharted territory", we, therefore, have no prior history to use as benchmarks. In this case, however, it is not as difficult as usual because we have the luxury of having the S&P 500 largely trailing the Dow and still lingering underneath its all-time high (at the time of this writing).
While the Dow is the world's most popular benchmark, the S&P 500 is the most significant because it has a very good balance between broadness and quality. This characteristic of the S&P 500 is the central reason why it is used by nearly all equity market professionals as the "main" benchmark for U.S. equities.
We, therefore, looked there to set our next target point for a turn, even if it turned out that the Dow was in the lead.
To arrive at a good projection for the Dow's first challenge (or resistance) point in this all-time-high territory, we used a concept covered in the Broad Market Class that we call "translation of Support and Resistance." We were not going to do any short-term analysis for this particular week we discussed and were just focusing entirely on the big picture, as well as what we were expecting in the weeks and months ahead.
Chart Notations:
- The monthly chart of the Dow Jones Industrial Average addresses the Intermediate-to-Long-Term time horizon.
- In the previous chart, we arrived at the 12,200 mark (gray area) as the first challenge area in the all-time high territory. We allowed a margin of 100 points in either direction. (Note that 100 points in the Dow is less than 0.8 percent of its value). And, how did we arrive at that value? We took or "translated" resistance in the S&P 500 -- a market highly correlated to the Dow -- and applied it here. We shall see this in the next chart.
- The arrows designate the directional bias for this particular time horizon (Intermediate-to-Long-Term). If we find a market that is able to sustain trade above the gray area, this is full-on bull market territory. On the flip-side, sustained trade below the prior high (red line) puts the market vulnerable to getting sucked back into the bear market range.
- We, therefore, made an overall neutral Intermediate-to-Long-Term posture in between the former high (11,750, red line) and our target zone (~12,200, gray zone). The reason for this was the high probability that what we were seeing here was an unsustainable breakout. A SUSTAINED move into the bull market territory (green arrow) had significantly less probability than movement back into the bear market range (red arrow). This is because of 2 very important reasons:
- The main benchmark of U.S. equities, the S&P 500, was still within the confines of CORRECTIVE activity (discussed next).
- The NASDAQ, the market premier measure for speculative behavior or "appetite for risk", was still in a coma from the dizzying 84 percent loss between years 2000 and 2002. We cannot have a bull market when the speculative market is still in the hospital ICU. A bull market is characterized by a movement of primary measures (such as the DOW and S&P 500, in tandem with a strong speculative market).
A move into bull territory would make it easier to trust this breakout because the sky is the limit, but, until then, it would be wise not to trust it. Now, let's look at the S&P 500.
Chart Notations:
- The monthly chart of the S&P 500 shown previously addresses the Intermediate-to-Long-Term time horizon
- The design of the long-term trend in the S&P 500 was very different from that of the Dow. Note that it was trailing way behind and was still within the confines of "corrective behavior."
- We applied the .786 Fib Retracement here as the next resistance point and took that and translated it over to the Dow to arrive at our 12,200 resistance point there, just using some elementary math.
- In the S&P 500, the .786 Fib retracement is the final frontier of resistance. A sustained trade above that point would put a 100+ percent retracement into play. We would deal with that only if the market was able to exceed 1385.
- In the meantime, note that, in more than 4 years of trading since the 2002 low point, the upward trend in the S&P 500 (which is corrective of the prior decline) has had no pullback of greater than 9 percent magnitude. It has been a great, and very consistent, environment for U.S. investors; returns were positive almost all the way in those 4 years.
We are now reaching the stage in long-term market cyclicality when the market is ripe for a good dose of profit-taking. As we near this critical resistance point, what is likely to be the largest and fastest decline since the 2002 low point is imminent (relative to the time frame discussed). If the largest decline since 2002 had a magnitude of 8 - 9 percent, that means that, if the market reacts to the .786 Fib retracement at this important cyclical juncture, the decline is likely to exceed 9 percent in magnitude. It is also likely to be a fast one.
We would continue to maintain this posture, as long as the S&P 500 continued trading below the 1385 mark. The weeks between then and now would be very pivotal in the markets. We would continue to tread carefully, as we always do, as the market continued its progress through time.
Until next time: Good Luck! Fernando Gonzalez
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