The "Inflection Day" Rally  

The granddaddy of the market confirmation principle, Dow Theory, states that each index (Industrials and Transports) must confirm the other in order for a move (up or down) to be considered sustainable. If one index makes a new recovery (not all-time, necessarily) high or low, the other must confirm that move with its own recovery high or low for the move to be considered sustainable.

In what is becoming known as “inflection day*”, March 17 witnessed the Dow Industrials break to a new low but the Transports failed to confirm that low (see first chart**). Subsequently, stocks marched ahead with each successive new recovery high in each index being matched by the other.

For some less-schooled market technicians, that’s all she wrote. We currently have a non-confirmation that occurred on inflection day and its off to the upside races. For the moment, let’s accept the trend call of the Dow Theory but not stop there. Let’s incorporate a few other indicators (specifically momentum related) and try to patch together a technical analysis forecast for the next several months (something that efficient market types say is impossible).

The second chart** provides several detailed momentum related indicators that I have found to be of considerable short-term value. A close examination of the Momentum, MACD, and Slow Stochastics indicators for the relatively strong Transports all point to one conclusion – the current rally has weak momentum underpinnings. Momentum has failed to produce a higher high, MACD is at a crossover point (to the downside), and the ultra short-term Slow Stochastics has already crossed and is headed south.

None of the above indicators suggest a reversal of the current rally. However, they all point to what is likely to be a very short-term mediocre to down period (probably lasting until Memorial Day, the unofficial start to summer here in the US). After that, a summer rally seems to be in store as the non-confirmation signal on inflection day was followed by a confirmation signal thereafter.

Investment Strategy Implications

Technical analysis (TA) is one tool that can be relied upon for market timing and portfolio strategy purposes. The above signal (one of several in the TA toolkit) suggests a tradable rally into the summer after a brief respite in the very short term***.

The other tool, fundamental analysis, tells a decidedly different story – one that will play out into the fall and 2009. I suspect that the technicals of market will begin to signal that ugly period once the current inflection day rally has run its course.

*Bear Stearns deal (steal?) results in a change in the credit crisis. **click images to enlarge ***expect to hear the tired phrase “sell in May and go away”.

*To learn about "Sectors and Styles Strategy Report" newsletter and other subscriber benefits, click here.