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STOCHASTICS


Tells For A Top?

09/13/05 08:06:11 AM
by David Penn

The top in 2000 was preceded by a running negative stochastic divergence on the monthly charts. Now, a similar pattern is emerging in the autumn of 2005.

Security:   $SPX
Position:   N/A

It's one thing to talk your "book" -- that is, to speak positively about certain outcomes that will directly benefit you if they pan out. It is something else altogether to suggest that your preferred outcome isn't just your preferred outcome, isn't just the most likely outcome, but is in fact the only ethnical or moral outcome possible.

That is the only way to characterize the self-serving chorus of bulls who have convinced themselves that nothing short of the full wrath of God should descend on Alan Greenspan and the Federal Reserve Board should they decide to keep raising the "cash rate" at the measured pace that has been their catechism for more than a year.

Unlike in June--the last time the bulls were convinced that the Fed's rate-raising campaign was over--this time it is the rubble of New Orleans left behind by Hurricane Katrina that has the bulls ascending the high ground, bullhorn in hand, to let the world know that now is not the time for finger-pointing, blame-gaming or Fed funds rate-raising. Now, instead, is the time for pulling together--and squeezing the shorts, the bulls say.


Never mind that Federal Reserve governors--from Moskow of the Chicago Fed to Santomero of the Philadelphia Fed to Yellen of the San Francisco Fed--have been "rather public," as analyst John Mauldin recently put it, about the need for a less accommodative Fed funds rate. Never mind that the doves--those Fed governors for whom no accommodation is accommodation enough--have yet to be heard from. (Could it be because there aren't any?) Buyers of stocks want stocks to move higher. And if the Fed's rate-raising policy stands in the way, then buyers of stocks will shame the Fed into "skipping a month" when it comes to rate increases.

Just what sort of reprieve these bulls think the markets will really be granted if the Fed plays "skip a month" is beyond me--especially if the measured pace of increases continues after the pause. In some ways, the bulls remind me of the kind of people who think advertisements that boast "buy now and pay nothing until 2006" represent some colossal bargain--or those people who see some helluva cool $200 tech gizmo and think they are getting a bargain when the salesman offers it to them for only $8 a month (for 48 months).


FIGURE 1: S&P 500. A running negative stochastic divergence in this monthly chart of the S&P 500 suggested a waning momentum in 2000--and hints at more of the same in 2005.
Graphic provided by: Prophet Financial, Inc.
 
I say all that to say this: Perhaps we are about to embark upon another massive bull leg higher--even if the bull market from the late 2002 lows never really ended, as Figure 1 makes abundantly clear. But there is ample technical reason for caution--caution that is today nowhere in evidence in the marketplace for financial assets.

The latest addition to the Caution Caucus comes courtesy of a 10-year monthly chart of the Standard & Poor's 500. Note how in the years and months leading up to the top in 2000, the stochastic indicator was making a series of lower highs. Starting with the stochastic peak in spring 1998, there is a lower stochastic peak in January 1999 as prices climbed higher and a stochastic peak that was lower still in earliest 2000--once again with prices climbing ever higher. This running, or multiple, negative divergence was a powerful warning that stocks were running out of momentum on a monthly scale. As such, any correction that resulted from the divergence between rising prices and a falling stochastic was likely to be significant.

And "significant"certainly describes the bear market that ensued, as the S&P 500 fell from a peak of over 1500 in early 2000 to a low of less than 800 in two years.

A similar setup appears near completion in autumn 2005. Matching the S&P 500 price highs in earliest 2004, early 2005, and autumn 2005 are, so far, a set of lower stochastic peaks. For what it is worth, the moving average convergence/divergence (MACD) histogram is reflecting a similar pattern. What this suggests is that if the S&P 500 does begin to pull back, investors, speculators, and traders would be well-served to be on guard in the event that any pullback in autumn 2005 turns into the same sort of conclusion reached by the market the last time a series of running multiple divergences appeared on the monthly charts of the S&P 500.




David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine, Working-Money.com, and Traders.com Advantage.

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