Still A Bear Market

06/05/09 12:42:25 PM

by Alan R. Northam

Much commentary of late suggests that we are now in a new bull market. However, the basics of technical analysis says otherwise.

Security: $INDU
Position: N/A

There has been a lot of commentary written lately about the stock market now being in a bull market upward trend. While this may be true, I want to say "Not so fast!" It is easy to get caught up in the euphoria surrounding the marketplace these days and go along with the flow that can easily influence our ability to analyze the markets objectively. We need to step back from all the hoopla and take a fresh unbiased view of the stock market.

One of the most basic but yet most reliable methods of technical analysis is known as peak and trough analysis. All other forms of technical analysis are basically derivatives of these. Without going into a lot of detail, let it suffice that as long as a market continues to move in a direction such that it forms lower peaks and lower troughs, the market trend is downward. This definition of a downward trend is derived from Dow theory. Dow theory also states that this downward trend remains in effect until the market forms a higher low followed by a higher high.

In Figure 1, I show the daily bar chart of the Dow Jones Industrial Average (DJIA). This chart shows that the DJIA continues to make lower peaks, labeled LH for lower high and LL for lower troughs (lower low). The DJIA has not yet formed a higher high or peak, followed by a higher low or trough. Therefore, this market is still in a downward trend.

To break the downward trend, the DJIA must move above its previous peak. I have drawn a red horizontal resistance line, labeled "key resistance," which represents the price level that must be penetrated to break the downward trend. As can be seen, the DJIA continues to trade below this price level. If, however, the DJIA manages to penetrate this key resistance line, it does not mean that a new bull market has emerged. It only means that the downward trend has been broken. A broken trend then calls for a change of trend but not necessary a trend reversal. A change of trend can mean that a more shallow downward trend, a horizontal trading range, or even a new upward trend can emerge from the broken downward trend.

FIGURE 1: DJIA, DAILY. This chart of the DJIA shows peak and trough analysis, the key resistance line, and a 200-day moving average.

Graphic provided by: StockCharts.com.

Another common method of measuring whether a market is in a downward or upward trend is by examining the 200-day moving average. For this reason, I have included the 200-day moving average on the price chart. Technically, as long as a moving average is moving in a downward direction, the trend is downward. Knowing that moving averages are trailing indicators, a market trend normally changes directions ahead of the indication of a moving average. So when a moving average changes directions, it does so after the fact.

For this reason, using moving averages to indicate the direction of a trend is inferior to peak and trough analysis. Nevertheless, it is still a good indication of the direction of a market trend. Having said that, a moving average cannot change direction as long as price remains below the moving average when the moving average is moving lower. Looking at Figure 1, note that the 200-day moving average is still pointing downward.

As long as price remains below this moving average, it cannot change direction and will continue to move lower. Therefore, as long as price remains below the moving average, the moving average is an accurate indication of the trend. It is only after price has moved above a moving average does the trend change direction and the moving average is delayed in detecting this trend change.

In conclusion, the DJIA has been forming lower peaks and lower troughs and has not yet formed a new higher trough followed by a higher peak. Therefore, this market remains in a downward trend. Further, price remains below its 200-day moving average, further signaling that the downward trend is still in progress. To reverse the downward trend, the DJIA must make a higher trough followed by a higher peak. In addition, price must move above the key resistance level. Once the 200-day moving average changes direction from down to up, it will confirm that the DJIA has reversed its major trend from down to up.

Alan R. Northam

Alan Northam lives in the Dallas, Texas area and as an electronic engineer gave him an analytical mind from which he has developed a thorough knowledge of stock market technical analysis. His abilities to analyze the future direction of the stock market has allowed him to successfully trade of his own portfolio over the last 30 years. Mr. Northam is now retired and trading the stock market full time. You can reach him at inquiry@tradersclassroom.com or by visiting his website at http://www.tradersclassroom.com. You can also follow him on Twitter @TradersClassrm.