Correction Over: On to Phase Three

Shareowner, Jul/Aug 2004 by Taylor, Patrick

The Dow

Industrials

When I wrote the last article, stock markets were already experiencing a correction which began in February 2004. The Dow Industrials dipped briefly below its 200-day moving average in the second week of May and made a low in the third week, at which point, the volume line gave a buy signal.

Transports

The Dow Transports dipped below its 200-day moving average in the third week of March. Some Dow Theorists declared that a bear market had begun because the Transports were no longer confirming the Industrials. Then the Transports' volume line gave a buy signal, and it has been in an uptrend ever since.

Others

Both the Industrials and the Transports crossed back above their 200-day moving averages in the fourth week of May. It should also be noted that the NYSE, S&P 500, Dow Utilities and the Advance-Decline Line declined to their 200-day moving averages but did not break below them. Then, in the fourth week of May, they all bounced off their averages with rallies that were greater than the Dow's.

The Advance-Decline Line rallied with an impressive 7-to-l ratio of advances to declines. Furthermore, the Net New Highs (highs minus lows) in two weeks came back from -956 to 81, also impressive.

As evidence of a very oversold market, the NYSE's 5-week Advance-Decline Ratio (outlined in the previous issue) reached a low of 28.2% in the first week of May. That indicator often gets down into the mid- to low-thirties but rarely does it drop below 30%.

So, it would appear that with the Dow crossing back above its 200-day line, the correction is over and Bull Phase Three has begun.

Nasdaq & Toronto

The statistics were far less noteworthy for the Nasdaq and the TSX. In both cases, the averages dipped below their 200-day lines and regained them but with lagging volume lines and positive, but puny, advance-decline ratios and Net New High recoveries. However, rallies by the 5-week A-D Ratios; stocks above their 10- and 30-week moving averages; and, percent of Groups Bullish have been reasonably good - although not with quite the same gusto as the NYSE's.

Phase 3

The major consensus for the correction was fear of higher interest rates. As Joe Granville used to say, "the obvious is obviously wrong". The price declines in the bonds and utilities were not matched by the declines in the volume lines. As a matter of fact, the volume lines for bonds have given buy signals and the Dow Utilities' volume line made a new high in the fourth week of May. Remember, that when everyone knows why the market is coming down, chances are the decline is a phony. But when the market declines and nobody knows why, it's time to take profits.

Here's what to look for in Bull Phase Three. The Advance-Decline Line should have recorded a major peak at the end of the second phase and begin to diverge from the Dow Industrials. The Net New Highs should attempt to exceed their previous peak but fail to do so. A serious divergence between the Transports and Industrials may occur, although that is not an absolute requirement. The Dow Industrials should pull away from the broader indices. Economies news should be very bullish.

Secondary offerings, mergers and stock splits should be occurring frequently - but not for bullish reasons. secondary offerings always come to market when prices are highest. Why would you want to raise money when prices are low? Corporate mergers most often occur at the top.

Here's a couple of examples: Prudential hated Bache at $8 but loved it at $32; the Canadian banks got into the brokerage business at the height of the last bull market. If they had waited until October 2002, they would have picked up some pretty good bargains.

Stock splits most frequently occur near the top of a bull market. If insiders want to sell, it will be harder to sell stock at $50 a share than if they split it 2 for 1 and offer it for sale at $25. Stocks splits should be viewed as distribution gimmicks.

And let's not forget TIME. Twentyone to thirty-three months have gone by since the last major market bottom in October 2002. This indicator alone warns you that the bull is aging.

PATRICK TAYLOR IS AN INDEPENDENT TECHNICAL ANALYST