Charting Asia: The Dow's Stress Test Rally

The debate rages on — Is this a new bull market or just a bear market rally? Have we bottomed out? Are the markets turning for real? Let's see what the charts have to say.

The charts highlight the difference between a rally and a trend. We are accustomed to thinking of a rally as a short-lived upwards movement. Time is a factor in separating a rally from a trend, but it is not the most important factor. The difference between a rally and a trend is the way the trend tests and retests a rising support line, or trend line.

Let's take a look at a couple of examples.

The Dow has all the features of a extended rally, but none of the features of a trend. On the other hand, the Hang Seng Index has the features of a trend that is initiated by rally behavior.

A trend has a pattern of rally, retreat, rebound, rally and retest of the trend line. This is shown in Chart A (Hang Seng Index). The April retreat is a significant 'stress test' of the trend and it finds support at the lower edge of a long term consolidation support and resistance area that has been developing since September 2008.

guppy rally 1 may 12.jpg

There are two other important supporting features. The first is the consolidation pattern of sideways trading in a band over several months from October through to March. This provides a foundation for the trend breakout.

The second is the character of the retreat and rebound. The rebound develops from the upper edge of the long term GMMA. Additionally, as this retreat develops there is no compression in the long term GMMA. The market absorbs this retreat. Investors step in as buyers because they believe this retreat is an opportunity to join the rising trend. The width of the long term GMMA shows investors support for the trend.

Rally behavior is different. A rally has a single trend line that has not experienced any significant rally and retreat behavior. This is chart B, the Dow. It is difficult to place an accurate trend line on the Dow chart. The trend line that most correctly defines the behavior is shown. Note the key difference. There is no rally, retreat and rebound activity in this period. It is simply a series of minor tests of the support function of the trend line. This behavior underlines the rally characteristics of the Dow.

guppy rally 2 may 12.jpg

So here's the nasty question. If a trend includes a rally, retreat and rebound then where is the rebound point for the Dow when the current rally collapses? In this 'stress test' where is the bottom line located? Is there weak support near 7,500 based on the spike lows in November? Or is there a support near 6,500 from the March 2009 lows?

The separation in the long-term GMMA is narrow. This shows there isn't strong support from investors. This narrow band also provides weak support for any market retreat. Unlike the Hang Seng, there is a low probability investors will step into the market and buy as the index falls. There is a higher probability they will join the selling and accelerate the continuation of the downtrend.

Rally or Trend?

The difference is reflected in the Dow's performance during 1929-30 confirms. The chart for this period shows the fast rally rebound that lifted the market 48 percent before dumping it again into the collapse of 1930 and 1931.

The market also rose again with rallies of between 23 percent and 35 percent on several occasions in 1930 and 1931. Great trading, but shocking investment opportunities. This type of situation remains a possibility even in these apparently ebullient times where many public figures are pronouncing the end of the recession. They are in many cases the same people who were unable to identify the start of the recession.

Fear and caution should not blind us to the opportunity to identify good trading opportunities. There are excellent returns available from rally and prolonged rally behavior in individual stocks. However, the strategic outlook suggests it is too early to treat these as investment opportunities. We trade for profit and act with caution.

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