Dow Technical Outlook 081013 - A Short Term Market Bottom has Formed

Dear Friends,

The stock markets throughout the world has been too volatile. We are about to see a more calming / stabilizing market, with a slow but progressively narrowing range in the daily swing value (High minus Low) in the next one week.

However, given the nightmare that investors and even speculators have just gone through, we can expect the stock market, the Dow Jones Industrial Average (DJIA) Index included, to remain jittery and exceptionally nervous for the immediate future.

The Dow (DJIA) has just undergone its worst week ever in its entire 110 years of existence. In my personal opinion, the worst should be over ........ for now.

Why? Because we have seen extreme panic selling for the most part of the week, and distressed forced selling in the later part of the week, and most importantly, the bulls in the Dow has made some attempt to fight back on Friday, 10 October 2008.

The Weekly Chart below provides us with a strategic bird's eyeview of the situation.

The Dow started the week at 10,322.8 and dived to a low of 7882.51 before closing at 8451.19. This represented a downward swing value for the week of 2,440 points or a crash value of 23.6% from its open. Even after the rebound to a much higher close, i.e. an upturn of 568.7 points or 7.2% from its lowest point, within the same day, the Dow still closed down 1,871.6 points down. This represented a loss of 18.1% in stock value in just one week and this stock market crash will have some serious implications in the longer term.

For one, if any CEO was still undecided at the beginning of the week as to whether to take his firm through a massive retrenchment exercise, today, he will have no more doubts to do so. Furthermore, if there were any doubts at the beginning of the week as to whether to invest in capital expenditure for business expansion, today, the answer will be much clearer, i.e. to postpone the project indefinitely, till a much better economic climate ensue.

I do not have exact data on how much money was lost by investors in stock markets throughout the world, but assuming a rough estimate of US$60 trillion stock valuation worldwide, a 20% loss would translate to US$12 trillion, i.e. US$12,000 million million! That is one heck of a lot of money for the world to lose in one week. And we haven't even start counting the drop in property prices throughout the world in the next 6 to 12 months. Very few property investors, except for the bravest of the bravest, would venture to buy properties today, unless it is priced at distressed forced selling level. There are plenty of sellers today, but one would be very hard pressed to even get an offer, much less a decent offer today.

What does this mean? To understand the situation, we need to study the Dow's performance between the years from 1929 to 1935.

We review both the Daily and Weekly Charts of the Dow from October 1928 to 31st December 1935 to gain deeper insights on what happened in the past, so that we have a good idea or foresight of what may happen in the future.

The two periods are similar in the sense that both stock market crashes are due to banking crisis and property market crisis, also known as a Balance Sheet Recession.

In my opinion, this is the worst type of economic crisis that can hit an economy. If we add the last ingredient, i.e. a currency devaluation crisis, we would get THE PERFECT STORM. As is, this Financial Tsunami is bad enough.

From the Daily Chart, we observe that the Dow peaked on 3rd September 1929 at 386.1. From this historical peak, it dived down by 65.6 points or 17% to a low of 320.45 as at 4th October 1929, in slightly more than a month. It then rebounded to a lower Pivot High of 358.77 on 11th October 1929. This means that the Dow had retraced about 38.32 points or 58.4 % of its first downswing, from its historical high.

The Dow Theory has been in existence since 1904, with numerous publications from Charles Dow, the creator of the Dow Jones Industrial Average Index as well as the Dow Theory to analyze the Dow's performance. However, it is important for us to visualize exactly how exceedingly tedious it would have been at that point in time, for a technical analyst to maintain the necessary data by hand. Thus, technical analysis had significantly less influence on the stock market performance then, in terms of self prophecy, than it probably has as at today.

The important point to observe is that the 2nd Downswing between 11th October 1929 to 13th November 1929, did it in for the Dow in 1929, and this is known as the Great Stock Market Crash of 1929. From the Pivot High of 358.77, the Dow bungy dived to an unbelievable low of 198.69 before starting its "Climb Back to Health". This represents a Downswing Value of 187.41 points or 48.5% from the historical high of 386.1, within a period of less than 2.5 months ........ a most significant stock market crash.

The Dow has experienced a downswing value of 6,397.5 points or 44.8 % from its historical peak of 14280 set on 11th October 2007 to the latest low of 7882.51 experienced only as at last Friday, 10th October 2008, which represents exactly a year in duration. This means that today, investors are experiencing a lot less pain than in the Great Crash of 1929. Although the severity of the crash has been about the same, i.e. 44.8 % for 2008 compared to 48.5% for 1929, the one year duration had given investors sufficient time to get out if they wanted to.

All this is in the past, and whilst it is interesting, what we want to know is what is likely to happen, or may happen in the foreseeable future. This is exactly why it is so important to study the Dow Performance for the next few years after the crash. From the Daily Chart, it should be noted that there is usually a quick recovery in the form of a V shape, and in this case, the Dow recovered from extreme distressed forced selling to the level of 267.56 by 9th December 1929. This represented a gain of 68.9 points or 34.7% from its crash low of 198.69. From a Retracement Value perspective, the Dow regained 36.7% of its total downswing value of 187.41 points.

Thus, the current scenario seems to be a potentially highly lucrative, profitable opportunity to take a risk on. Using the same statistic to provide us with a rough idea of the potential target, we would "hope" that the Dow repeats its 1929 "Climb Back to Health" and this time, "Climb Back" to the level of 10,560, yielding a return of 34% from its low of 7882.

It should be noted that profit taking is bound to set in after such a scare, and this time will be no exception. For half a month, the Dow dropped back from its 1st Post Crash Upswing to a low of 226.39 set on 23rd December 1929, and then, decided it would reward investors with a good Christmas present, by moving up higher on a steady, well behaved basis, for four months. This culminated in a high of 297.25 set on 16th April 1930.

This point is extremely critical. There is a world of difference between the Dow being above its SMA200, i.e. the Green Line, and continuing below it. This is the Ultimate Battlefield Line of Defense between the Bulls and the Bears, and if the Dow remains below the SMA200, then it CONTINUES to be in Bear Market Territory. If it breaches through the SMA200, it is still unclear as to whether such a breach is sustainable in the medium term. Other technical conditions must be complied with before we can declare the Dow to be in Bull Market Territory once again. It is not possible for me to explain in detail all the necessary conditions, which would tantamount to a short book on technical analysis, and so, for the present, it is important to note that the Dow DID NOT breach the SMA200, and as a result, it turned down once again, and resumed its Primary Bear Trend.

So, even if we take a Long Trade to exploit the opportunity in this coming recovery, please note that the recovery is merely a Medium Term Secondary Wave Uptrend Correction (W2) in a Long Term Primary Wave Downtrend (W1). Do not mistake this coming uptrend to be a Trend Reversal of the current Long Term Downtrend.

From a Fundamental perspective, we know that the worst is not over, although it feels like we have undergone some very severe pain. 2 more banks failed in the US over the weekend, bringing the total to 15 now. A few hundred are estimated to fail by the time we get through this economic crisis. There are other similarities between the 1929 Crash and Today's Market. Share Margin Facilities were rampant and excessive in 1929, and although there have been no criticisms that share margin facilities given to clients are to such a large extent this time, I believe it is still quite a substantial amount, and this did aggravate the distressed forced selling of shares over the past one week.

Another key factor for the Great Crash was the founding of mutual funds or unit trusts, which at that time was generally referred to as Pooled Funds. The cash redemptions, i.e. customers wanting their money back and thus, selling their unit trust shares back to the Unit Trust Firm, forced the fund managers to perform distressed forced selling of shares and this significantly aggravated not only the less fundamental stocks but also the strong fundamental stock prices.

One may think that General Electric is cheap based on fundamental analysis. However, in a Bear Market, it usually does get even cheaper, despite its already attractive valuations. Why? Because fund managers who are forced to raise cash to pay customers for their unit trust redemptions have to sell something, and in doing so, they inevitably have to sell even the supposedly fundamentally attractive stocks. This is the reason why Fundamental Analysis alone cannot work well to make money for us, especially more so in today's fear driven market.

Let's look at the Dow Weekly Chart for the years between 1928 to 1935. You will notice that the Dow retraced its downturn to near the 300 level, i.e. near its Weekly SMA50. Here, one single candle represents a week, and thus, SMA50 represents the Simple Moving Average of 50 weeks, which is approximately 250 trading days, and thus, the Weekly SMA50 performs in almost a similar manner as the Daily SMA200.

IMPORTANT - You will notice that the Dow went down after this peak near 300, i.e. 297 level to be exact, to an extremely unbelievable Low of 40.56 set on 8th July 1932. This means that the Dow dropped a total of 345.5 points or 89.5% from its historical peak, over a period of close to 3 years. This was how a US$100 stock ended up being priced at US$1 only. Please understand that the component stocks of the Dow represents some of America's finest and most respected public listed companies, and thus, it would be reasonable to expect other stocks to drop even more significantly than the Dow component stocks. This was how some stocks ended up with a price of 10 cents from their historical top of US$100 per share.

If we look further out in the Weekly Chart, we will also notice that with exception of the stellar Dow performance in 1933, where it gained approximately 30 points or 50% of its value, the Dow remained fairly flat in performance until 1st quarter of 1935. This is a long, long wait, to get a decent return, even for a patient investor. Another interesting observation is that the Dow bottomed out in July 1932, about 6 months to a year before the economy hit rock bottom in terms of the Great Depression. By 1933, about 10,000 banks had failed in the US, and Unemployment Rate had reached 25% i.e. 1 in 4 people were out of job.

If you wish to understand life in the Great Depression, I would encourage you to read the novel, "The Grapes of Wrath" written by John Steinbeck, published in 1939. I have not read this book, but I have watched the classic Black and White movie of this novel. Back then, people who found work accepted the ridiculous remuneration of 10 cents per day, when it used to be US$1 per day. This means that if you are earning $1,000 per month today, you will accept the pay of $100 per month, after begging the potential employer for a long, long time. Work was not guaranteed, and if for some reason, you either hurt yourself or fall sick, you will lose your job. This is still not so bad, except that many innocent and conservative people who never speculated in the stock and property markets lost their entire life savings in the bank collapses, and then lost their job. They lived life with whatever savings they had left, and subsequently based on whatever they could borrow from whoever still had any money left, because they could not get a job for 5 years. That's what a Great Depression is all about.

Imagine both you and your spouse losing your jobs in this coming Great Recession, and not being able to earn a single cent income for the next 5 years. Imagine also that you cannot sell your properties, and after you have used up your entire life savings, you are down to the last chair and pot to sell, just to pay for the electricity and water bill which are 6 months in arrears. Imagine also, that every relative and friend you know are in a similar position, and that those who are better off are not taking your phone calls because too many people have owed them too much money. It is scary for us, but it was very real for the people who lived and died through the winters and starvation of the Great Depression of 1929 to 1939. Ten long years of suffering and pain.

It is extremely important for us to realize the consequences of a potential failure by the key governments of the world to stop this Financial Tsunami from turning into the Perfect Storm of Financial & Economic Disaster of Epic Proportions.

I also attach two Daily Charts for further analysis.

The 1st shows us the bigger picture of the situation where the Dow has been trending down since it achieved a historical high in October 2007. In the last Secondary Correction to the Primary Downtrend, it went close to the 12,000 level before succumbing to a steep crash. There is a Strong Resistance Zone between 10670 to 11,040, and thus, it would seem that our earlier analysis for a Retracement to 10560 is consistent with the Technical Support and Resistance Level.

The Daily Chart below is a Zoomed In version of the chart above.

What is interesting here is the wide range Spinning Top candle formed last Friday, 10th October 2008. From the Chart below, we can see that the Bears have been winning the battles every day of the week. This is depicted by the Red Candles which shows that the Opening Price is lower than the Closing Price. Thus, for the whole week, the Dow opened at close to its high, and then went lower, and closed mostly at its low. This is mostly represented by long candles with red bodies, but short wicks (thin vertical lines) below the bodies.

Last Friday's candle is special because it is represented by a small body almost in the middle of the long candle. The rest of the candle is made up of two wicks, i.e. one below and one above. This is the Spinning Top Candle. What it means is that the Dow opened higher than the close, and it traded in a wide trading range of between the high of 8901.28 and a low of 7882.51 within the same day. This gives an extremely wild trading day range of 1,018.77 points or 11.9% of its opening level of 8568.67. Normally, the Dow trades within a daily range of less than 2% or 170 points, and even this intra-day swing value would be considered quite a volatile day.

Theoretically, such a volatile trading day will present many opportunities to make money. However, practically, it would be extremely difficult to discern a proper trend to trade under such wildly gyrating conditions. This means that most people would get whipsawed and stopped out of their trading positions, i.e. incur a loss on their trade, rather than make money.

What is interesting with this candle is that the Bears tried to do on Friday, what they have done for the whole week. However, this time, the Bulls fought back with a vengeance, and the Dow pushed higher; to as high as 8901. Nevertheless, the Bears rallied to push the Bulls back down, and thus, the Close was just slightly below the Open at 8,451.19.

Considering that the Bears had been having an unchallenged position as the winner of the battle, the fact that the Bulls were able to hold their ground this time around means that there could be a potential reversal in trend in the Short Term. Japanese Candlesticks tend to give short term (3 to 5 days) signals of the trend direction, and here, the Spinning Top is signaling that the market is uncertain, where it used to be a decisive Bear Market in the past.

Given the extremely long candle, and the historical analysis above, I am inclined to believe that the Dow has seen its market bottom; at least in the short term of the next one week or two. This means that we should be actively preparing to enter a LONG trade, assuming you believe my analysis to be reasonable and makes good sense.

However, translating this analysis of a high probability of a trend reversal into a trade is extremely difficult given the wide range of the candle. Whilst I believe that the Dow should not go lower than 7,882 in the short term, the fact that it closed at 8451 means that there is still room for it to drop by another 569 points ..... a lot of money to lose, assuming that it does really bottom out at that level. On the other hand, the Dow may just rebound quickly as we have seen in the past, and we will then miss the boat.

So, what should we do? I am inclined to wait for another day or two for the market situation to clear. There is no way of knowing what significant negative news will be announced in the next few days, and the still jittery market means that it will continue to experience wide daily trading range, which will progressively become more calm and stable as time goes by. If the market is kind, we will be able to get in a trade at a good position. If the market is unkind, then it will just go straight up when it feels like it, and the next thing you know, it has gone up by 300 points, and you still don't have a position.

However, I can't see the market going up too far before a wave of selling comes in. I expect this to be not so much an issue of profit taking, for few traders / investors bought and held shares through this weekend, but an issue of fear driven sales by people who had wanted to wait for a rebound before they sell.

Thus, in conclusion, I am inclined to wait for smaller range candles to form, which will provide me with even further clues as to the viability of this venture.

Best wishes,

Ooi

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