Trend Changes and the Dangers of Crying Wolf

Last week brought new all-time highs in the three major U.S. stock averages (Dow Industrials, Transports, and S&P 500) nearly every day, continuing the remarkable winning streak that began a bit more than 4 weeks ago and shown below.


Source: Bloomberg

We cannot, or should not, hold a grudge for what seemed at the time a break in the market’s long uptrend immediately preceding this latest rise. Any sell signal given in early October has by now been proven incorrect, as the market is rather clearly marching to its own, very bullish beat. And it’s not just technical (chart-based), as U.S. retail sales have again turned positive and consumer sentiment rose to the highest level in 7 years – both benefiting from the lowest gasoline prices in years.

While conceding that the bull market is alive and well, we nevertheless have the option of deciding how much to invest in stocks. The Dow Theory, and its emphasis on values and shying away from what appear to be risky markets, tells us that we needn’t slavishly buy stocks, or even hold many stocks, at these current, rarified levels. And without sounding too much like “sour grapes”, I still think that is the appropriate way to view today’s market.

I can’t help but think lately of the old story of the boy who cried wolf. The summer and early fall of 2014 brought us a series of what appeared to be increasingly significant trend reversal sell signals for the U.S. markets. Yet each of those was followed by a big upside reversal – sort of a “ha, ha – fooled you!” taunting by the market. The lesson of this series of fake-outs would seem to be: Sell signals by this market cannot be trusted.

[Read: Credit Markets Signaling Near-Term Caution]

Therefore, I suspect that at some point, when this bull market finally does end, prices will start dropping and people will just wink knowingly at one another – hey, it’s just another one of those phony market “crashes”. And few people will act on it. Until the market drops not 1500 points like last month, but 2000 or 3000 points, rallies a few hundred points, and then takes off for lower levels with a vengeance. The market that cried wolf once too often…

Our biggest protection against getting either faked out again, or ignoring any future market correction that turns out to be the real deal, would seem to be our old friends, the Dow Theory and the PTI. The Dow Theory (if we don’t count my “sort of” sell signal from last month) has kept us consistently on the right side of this bull market for years, yet I nevertheless see a possible future Dow Theory sell signal as rather problematic. Now that we have confirmed new highs in both the Industrial and Transport Averages, a legitimate (mechanical) sell signal would only come when 1) after a significant market decline, one or both of the Averages fails to make new highs, 2) both of the Averages subsequently fall below the lows of that significant market decline.

What worries me is the megaphone-type action of the market, as shown by the two diverging lines in this next chart, where swings on both the upside and downside have become increasingly volatile. One might envision the market selling off at some point here; what’s to keep it from dropping back into the 16,000s, or even back to the 15,000s as it did only a few short weeks ago? If the Industrials (and/or Transports) subsequently failed to make new highs and then, further went on to break below their latest bottoms, we’d finally have our mechanical Dow Theory trend change – but at what might be sharply lower prices below current levels. And after such a trend change, if followed (or preceded) by a break below the panic October lows, it would be easy to imagine the conditions about which Mr. Russell wrote over 50 years ago: “Often, on the advent of a bear signal, stocks drop so fast that it is impossible to obtain quotes on securities.”

Even with the PTI, or Primary Trend Index, which has done such a remarkable job of staying on the right side of the big trend, we see a similar danger. The next chart shows how both the PTI and its moving average (MA) have moved steadily higher for years, and that the PTI has never significantly fallen below its MA during that steady upward climb. Yet it has come back to, and a bit below, its MA numerous times, and therefore we would be foolish to take a minor break below the MA as a definitive sell signal.

No – we should want to see the PTI quite a bit below its MA, and below its latest significant low, before considering the PTI to have turned bearish. This translates into the PTI needing to drop below both its October lows and also its August lows which, once again, mean we might well see much lower prices before our PTI tells us to get out.

Overall, I suppose the message is clear: We have rather identifiable ways to know when U.S. equity markets may finally reverse trend, yet even if those trend indicators turn out to be correct (which seems a big “if” lately), they may well not kick in until prices are much, much lower than where we are now. Which finally takes us back to my earlier assertion that this market is just too risky for holding all but modest positions.

On a slightly different matter – remember when the Canadian market was fully confirming the strength in U.S. stocks, and when the rest of the world was at least more or less in step with the U.S.? Well that’s changed! As you can see, the Toronto exchange isn’t anywhere close to making new, post-crash highs, and neither is the Global Dow.

So good for the old U.S. of A! Out in front, nobody even close; whoo-hoo! Sure – Chinese stocks also keep making new multi-year highs, but are they’re still far below their 2007 price peaks. Thus, it’s kind of lonely out there for U.S. stock bulls, and that doesn’t seem to be a sustainable and therefore good thing. But there IS good news…

[Read Also: Don't Fight the Dollar]

The good news is that the precious metals complex, out of nowhere last Friday, turned in a potentially major trend reversal – at least on the near-term. The day started out glumly enough, with gold down yet another /ounce and buying support nowhere in sight. Just as I was reading why 0 was a reasonable next stop for gold, bam!, prices turned on a dime and within a few minutes, gold was UP /oz. Our favorite metal finally finished up a very impressive for the day, with silver, platinum, and the mining shares following its lead higher as well.

I find it difficult to get too excited about gold’s action, to see it as finally The Big Turn. The fundamentals just aren’t there, and technically, there’s more bearish evidence than bullish evidence out there. Take a look at the weekly chart, which filters out a lot of the day-to-day noise and emotion.

Last Friday’s rally can barely be seen here, and all that’s happened is that we’re back up against the old triple-lows of the 80s – which now represent resistance to further upside progress. The MACDs, shown below the main chart, are similarly unimpressed, and continue steadily lower. Sure – a journey begins with just one step and all, and we certainly could be seeing the earliest stages of a new gold bull move. But that’s no more than a tantalizing possibility at this point, so let’s not get too excited.

The above content was an excerpt of Richard Russell's Dow Theory Letters. To receive their daily updates and research, click here to subscribe.

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