Primary Trend Down

SPX – 1087.69

DJIA – 10,193

“When coming events cast their shadows before, the shadow falls on the New York Stock Exchange.”

-William P. Hamilton

When price overbalanced but time hadn’t, I wrote the bull market deserved the benefit of doubt, the technical readings recorded on May 6 the sort that would hold for at least one last rally to a new high. The bull case lost that benefit in this week’s pounding. The penetration of May 6 lows this morning, however slight, emphasize we shouldn’t dismiss the technical warnings. Time overbalanced using weekly data and the 3-day swing chart pattern for the S&P 500 (SPX) is one of lower highs and lower lows. Price and time overbalance combined with a 3-day swing chart downtrend indicate the primary trend is down.

There’s a clique that’s grown over the last 20 years equating bull and bear markets to percentages, recently proclaiming the market officially entered correction territory by being down 10% and they’ll announce a bear market when prices fall 20%. I’m not in that camp. The primary trend, typically lasting for years and labeled a bull or bear market, is governed by the business cycle and fundamental conditions, not percentage moves in the stock market. The primary trend swings between discounting the best that might occur (bull markets) and the worst that could happen (bear markets), often going to extremes in either direction due to emotional factors, but extremes were absent this time around at the April 26 high.

A bear market was signaled under Dow Theory on Thursday’s close, indicating the best for this cycle was discounted, particularly telling in face of steadily improving business data, albeit interwoven with systemic risk concern set off by weak hands (overleveraged countries) in Europe and the impact of dealing with the PIIGS’ debt on emerging market exports and developed nations living over their head, particularly the United States. The SPX also closed below its 5% weekly exponential average, the equivalent of a 200-day or 40-week moving average that I use to track longer-term trends.

The weight of evidence points to the cyclical bull market being over. How far the stock market falls and how long the decline lasts are unknown, but I’m not in the super cycle bear contingent. Following the March 2009 bear market low, my bias has been to expecting a series of cyclical bull and bear markets.

Under Dow Theory, the movements of the Industrials and Transportation indexes are considered jointly, using closing prices for both The action of one index must be confirmed by the other before reliable conclusions are drawn. It is bullish when rallies penetrate high points from preceding intermediate-term advances and declines terminate above the low points of preceding secondary corrections. Rallies in which either the Industrials or Transports fail to penetrate preceding intermediate-term high points that are followed by declines that slice below prior intermediate low points calls for a bearish interpretation. Note in the following chart of the Dow Industrials and Dow Transports following the secondary rally in mid-May how both closed below the May 7 lows.

The Dow Theory encompasses more than a mechanical reading of the averages, and incorporating an understanding of values, investor psychology and sometimes subjective calls to determine whether a rally or decline qualifies for a reading, it is not infallible. Nor is it is a system for beating the market because doesn’t make take tactical sense to wait for a confirmation to take action. For instance, the low today could have marked the end of the first section down (inconclusive and too early to call), or the bulls would say near the end of a brutal correction in a bull market not yet long in tooth. Slipping into the Elliott Wave world, I count a five-wave decline in the SPX hourly chart, which if it holds should be followed by an A-B-C rally, generally retracing one-third to two-thirds of the decline and followed by another five-wave decline at a minimum.

The Market Trend Indicator (MTI) was NEUTRAL last Monday but quickly slipped back into DOWNTREND on Tuesday. It is my favorite tool to identify and follow intermediate-term trends lasting weeks to months. Each index is below its respective 18% weekly exponential moving average, 1143.28 next week for the SPX and 10,639 for the DJIA. The New York Advance/Decline line is 3,115 net declines below its 18% average.

As for volume, there have been six 90%-down days since April 16 compared to one 90%-up day on May 10. Following a +52.3 net volume reading for the NYSE and +53.2 for NASDAQ on the mid-May bounce, this week’s selling resulted in a (70.9) hurdle rate for the NYSE and (71.3) for NASDAQ that needs to be overcome to indicate a change in trend.

From the high, the Energy, Materials, Financial and Technology sectors were down the most. It’s a negative that the bull market’s leaders are all under pressure. The other key markets I track continue to grapple with the problems of too much debt around the world and the political response to deal with the turmoil by going even further into debt. Policy options include debt restructuring or currency debasement.

Flight-to-safety buying drove government bond prices higher. I think a short position makes sense (with a stop above the May 6 high) once the SPX puts in an intermediate-term bottom. Gold sold off this week but held well relative to other commodities. I want to see new all-time highs on any recovery in the stock market or I start to worry about long positions that looked like it was beginning to discount potential deflation this week.

Harmonic Preview:

(Higher Probability SPX Turning Point or Acceleration Days)

May 27            (Thursday)

June 2              (Wednesday)

June 11             (Friday)

June 14            (Monday)

June 25            (Friday)

*We’ve had a streak of high-volume acceleration days that haven’t waited for these days to roll around. Mr. Market is a tricky devil.

Conclusion:

Tactics and discipline count more than predictions, a belief I overrode by covering most short positions prematurely and proving once again the wisdom of the observation. I promised my wife years ago that I wouldn’t make the same mistakes more than 1,200 times and I’m still well below 1,000. At least we were out of long positions early in the break but small profits on the short side versus letting profits run is not what planned, deliberate speculation is all about.

For remaining shorts, I recommend lowering the stop position to just above the May 13 high (SPX-1173.57). For the recovery rally, I would size positions (smaller) for a counter trend move. While small cap issues could still lead the advance, I plan to use ETFs tied to the SPX and NDX.

For investors, what’s your strategy for skinning the cat. Make sure you have one. If the first section of the bear market isn’t over, I think it’s a lot closer to the end that not. If you are the “buy low-sell high” sort and haven’t already implemented defensive steps, I think it makes more sense to take the most action after first recovery rally, generally the largest in a bear market.

The information contained herein is based on sources that William Gibson deems to be reliable but is neither all-inclusive nor guaranteed for accuracy by Mr. Gibson and may be incomplete or condensed. The information and its opinions are subject to change without notice and are for general information only. Past performance is not a guide or guarantee of future performance. The information contained in this report may not be published, broadcast, rewritten or otherwise distributed without consent from William Gibson.