Is The Recession Over?

08/10/09 10:27:34 AM

by Alan R. Northam

Is the recession over and the economy In recovery? One way to answer this question is by looking at what the financial market sector is doing.

Security: XLF
Position: N/A

There is a lot of hype in the media these days pointing out that the economy is starting to come out of recession. One way that we can tell if the economy is doing so is by looking at the performance of the financial market sector. As the recession bottoms and moves toward recovery, the financial market sector will start to improve.

Figure 1 shows the weekly bar chart of the financial market sector as measured by the Financial Select Sector SPDR (XLF). This chart shows that XLF bottomed in March 2009 and started to trade higher. In early May, XLF started a two-month long correction, forming a flag pattern. The flag pattern was complete when price broke out to the high side of the flag in mid-July. Flag patterns are typically continuation patterns signaling the continuation of the previous trend once the pattern is complete. Flag patterns also typically fly at half mast, which is to say that flags typically occur halfway through the complete rise. Thus, it becomes possible to estimate the completion of the upward price movement. To measure the complete rise, we then measure rise A from the bottom in March to the price peak in early May and add this rise to the bottom of the flag made in early July (see gray construction lines). This then provides a price target for the completion of the upward rally to be $24.

FIGURE 1: XLF, WEEKLY. This chart shows a flag formation and price target.

Graphic provided by: StockCharts.com.

In order for XLF to hit the price target of $24, it will first be necessary for this market to break out above the down-sloping red trendline. Overhead trendlines are resistance barriers and are typically price points where upward rallies are reversed back to the downside. When overhead trendlines are able to turn rallies back down, it is a signal that the rally was corrective and the downtrend has resumed. However, should price break through the resistance barrier of the overhead trendline, that is a signal that the rally off the March low is the beginning of a new uptrend.

One way to get an advanced indication as to whether the rally off the March low is a market correction or the start of a new upward trend is to look at volume. Volume normally decreases during corrections and increases when a new rally is under way. My favorite volume indicator is the on-balance volume (OBV) indicator, which measures the cumulative total of volume. The cumulative total of volume is arrived at by adding up volume and substracting down volume. When the cumulative total of volume is moving higher, it signifies that there is more buying going on than selling. Since volume normally leads price higher, as long as the OBV line keeps moving upward, price should follow suit. From Figure 1, note that OBV has been moving higher ever since the rally off the March low started. This is a sign that the rally is the beginning of a new upward trend in price. However, keep in mind that volume indicators are secondary to the price chart and only provides a hint at what price may do. Thus, the proof that the rally off the March low is a new uptrend lies in the breaking of the overhead trendline.

In conclusion, since price remains below its downsloping trendline, there is a high probability that the current rally will not reach the price target of $24 per share but will be turned back down by this trendline. However, the OBV shows that buying strength is stronger than selling strength and if this trend continues once price hits its overhead trendline, there is a possibility that price could break out above its downsloping trendline. If price does manage to break out above its overhead trendline and reach its price target of $24 per share, that will be a clear signal that the downtrend has ended and a new uptrend is in effect. Since the stock market normally leads the economy by several months, it may be premature to say the recession is over and the economy is in recovery until the financial market sector has established itself in a known uptrend.

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.