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Bulls Take the Stairs and Bears Take the Elevator


Of Dow Theory, volume, and stochastics.

I think the one lesson I have learned is that there is no substitute for paying attention.
-- Diane Sawyer

"Bulls take the stairs and bears take the elevator." I can't tell you how many times this Wall Street adage has been penned in the 12 years we've (Tesseract Asset Management) been writing market editorials. Sometimes, when it fits, it just fits. Last week we posed two thoughts in relation to the remainder of 2012. The first were inflection points; in that Nasdaq 2,590 (^NDX) and S&P 500 1,340 (^GSPC) were the proverbial lines in the sand and investors need to take heed if breached. We did not solely base this opinion on traditional technical trends. We reinforced this view with the weight of evidence relating to the GICS sector and industry makeup of these primary indices and their non-correlation to the 2012 highs. Last Tuesday the bearish party lit their candles as both indices closed below the threshold and real selling began to take hold.

We believe last week's market action was the first phase in significantly altering the market's course for 2012, and quite possibly the first half of 2013. For today, the topic is focused on three significant incidents.

Dow Theory, Volume, and Stochastics

On March 5 we articulated Dow Theory and its origination and summed up the all-important relation between new highs of the Dow Industrials (^DJI) and the Dow Transports (^DJT). It showed the negative divergence occurring and said to expect a reckoning around the corner. The technical underpinning of the Transports, at that time, was not necessarily bearish but needed to catch and confirm the move of the Industrials. And so Dow Theorist investors waited, and waited, and waited until… nope, missed it by that much. The Transports never confirmed the new highs before breaking back down below trend. Bad sign number one.

Click to enlarge

After price the next most important technical indicator is volume. Since the March 30 high in the markets the volume has been seeming average with no real outlying periods or days -- until last week. Many, including my firm, were calling the move from March a typical low volume correction which was related to buying rather than selling. This theory seemed supportable because on two days the week prior (May 7 and 8) the market made a stand. Both of these days were not only 'gap-down-reversals', they occurred with 20% plus increased average volume (greater than typical standard deviation anomalies).

Those two days gave technically significant credence to the inflection points previously outlined.

Now comes the second bad sign. Since the break of 1,340 the market has gotten precipitously worse as volume has been increasing every day. This indicates it is no longer a buyer's strike. Friday's action provided even further bearish clarity as 1,300 on the SPX melted like a hot knife through soft butter with a 40%+ increase above average volume.

Click to enlarge

As Friday wound down, and all eyes were pinned to Facebook's (FB) print IPO, another technical event was transpiring – a 0,1 stochastic. This, for all intents and purposes, is a rarity and typically only occurs on two occasions. The first is when the market is getting close to ending a bearish cycle and, oddly enough, the other is when it is beginning a bearish cycle. For example, the last two times this occurred was during the 2009 bottom and again in January 2008.

The Stochastic Oscillator is one of the various ways to measure market momentum. Over the last two decades we found it likely to be the most accurate when used appropriately and applied in a probability weighting setting. However, it is also likely the most misunderstood and misused secondary momentum indicator on Wall Street. Therefore, we will leave the stochastic debate for another day and leave you with this...

The market continually gives investors chances to see, read, and interpret its signals and warning signs about opportunities and pitfalls. Hence, the relationship between capital preservation and capital growth must be fluid when maneuvering though these waters. If not, you might as well be rowing a canoe with a spoon.

We hope this helps and finds you well.

Editor's Note: Read more at Tesseract Asset Management.

Twitter: @TAM_News
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No positions in stocks mentioned.

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