Monday, May 05, 2008

A rally with serious muscle (?)

Dow Theory Letters writer Richard Russell is still bullish on the action in the US market averages.

In recent weeks, Russell has become increasingly convinced that the strong action in the Dow Industrials and Transports off their January lows could signal an "all clear" for the economy and a surprise continuation of the recent upward trend in the US stock market.

He elaborated his position in a recent contribution to Barron's magazine entitled, "A Rally With Serious Muscle". Here are a few excerpts from that piece:

"Dow Theory bolsters the bullish case. On Jan. 22, the Dow transports recorded a low, along with the industrials. A rally ensued, followed by a decline in which the industrials broke to a further low that was "unconfirmed" by the stronger transportation average. From there, the transports headed higher, dragging the industrials along.

In April, both the industrials and the transports rallied above their February peaks. This was a Dow Theory bull signal and reconfirmation of the primary bull trend. Recently, both averages climbed to new recovery highs, another sign the market was ignoring depressing business and economic news.

A final study contributing to the bullish case is the short interest on the NYSE. It has reached a record 15.2 billion shares. In order to make money, short sellers need a declining market, preferably one that's falling amid rising volume, which is unlikely to occur. My guess is the short-sellers eventually will have to cover their positions -- that is, repurchase the borrowed shares they had sold -- resulting in a potentially explosive rally."

We last mentioned Russell's views on the market in our March 27 post, "Stock market wrap up".

In recent weeks and months, Richard Russell's readings of a possible continuation of the long-term bull market have provided an interesting contrary opinion to the who see the current market action as nothing more than a bear-market rally.

Still, (to my mind) there seems to be some disagreement between Dow Theorists as to whether or not the market has confirmed a bullish primary trend.

As noted in the exerpt above, Russell sees the April move by the Industrials and Transports above their February peaks as a, "Dow Theory bull signal and reconfirmation of the primary bull trend".

Meanwhile, as we noted back in our April 11 "Features" post, newsletter writer Tim Wood had pointed out that the recent upward moves in the Dow averages were not enough to confirm a primary bull trend, as they had not broken through their last joint highs reached in July, 2007.

Here's an excerpt from Tim's April 4 "Market Wrap-Up" piece:

"In looking at the chart below you can see that both averages last made joint highs back in July. In Dow Theory terms, this was known as a “secondary high point” in which both averages confirmed one another. From those highs, both averages moved into their August “secondary low points.”

It was the rally out of that low in which things began to deteriorate. As the Industrials pressed higher into their October highs, the Transports lagged, and in doing so failed to confirm the Industrials. This created a Dow Theory non-confirmation at the October secondary high points and is illustrated by the blue trend lines on the chart below. I wrote about this at the time and explained that upside non-confirmations served as warnings that something was wrong."

So it looks like we have some difference of opinion as to what constitutes a confirmation of a primary bullish trend.

Russell's thoughts on the market's discounting abilities are intriguing, but at this point, I'd say we might need to go back and see what exactly constitutes a primary bull trend, from a Dow Theory perspective.

Is the recent upward move by the averages above their February peaks enough to qualify as a bull signal? Or do they need to exceed their joint highs of July 2007 to reestablish the bullish trend?

A quick check of my copy of John Murphy's Technical Analysis of the Financial Markets reveals the following passage: "Dow...felt that both averages must exceed a previous secondary peak to confirm the inception or continuation of a bull market."

Does that mean Tim Wood is right in saying that the "secondary peak" was the joint highs recorded in July 2007? Is this still a bear market, in Dow Theory terms?

What do you say? Are we in a bull market or a bear market rally?