The stock market seldom has a “normal day.” Upon close analysis, each day is unique, with its own special pattern of change. One day, technology stocks will be hot and oil stocks will be out of favor. The next session might see oil stocks as the biggest gainers. One day the Dow Industrial Average will be up 60 points and the outlook for business development will appear favorable. The following session has the market correcting 100 points on the Dow, with growing inflation becoming a real threat.
MARKET PREDICTIONS
As J. Pierpont Morgan so succinctly put it, the market will indeed “fluctuate”; it tends to do that during every trading session. When stockbrokers are asked the question, “What will the market do?” they will either attempt to be positive or neutral on the subject. Many analysts will give a lengthy explanation of what the market should do and why. But it’s a simple fact that no one knows precisely what the overall stock market will do. The best one can hope for is to find a few signals of strength or weakness. One way to look for these signals is to look at trends.
STOCK MARKET TRENDS
The concept of looking at stock market trends began in the late 1800s with Charles Henry Dow, one of the founding fathers of Dow Jones &
Company and the Wall Street Journal. Dow followed market trends based on the Dow Industrial Average and the Dow Railroad Average (now the Transportation Average). He followed what he called “primary, secondary, and tertiary” trends. The creation of the Dow averages and definition of trends formed the basis of the technical analysis used today. The study done by Dow and later by editor William Hamilton eventually became known as the “Dow theory.” Here, we will look at trends in relationship to divergence, support, and resistance.
Three Trends
The daily movements of the stock market, the tertiary trends, are important in the way they affect the secondary and long-term trends. The longterm trend, or primary trend, shows the overall direction of the stock market for an extended period of time, usually six months or more. The term current trend can refer either to the long-term trend or secondary trend, which is a short-term trend showing a reaction or move in the opposite direction to the primary trend.
Stock Prices Move as a Group
One concept that all analysts agree on is that stock prices tend to move as a group. Dow Average, Standard & Poor’s, and Nasdaq (over-the-counter) stocks tend to move as a group. If they diverge from moving as a group, it is a signal of weakness in the stock market.
The tendency of stock prices moving as a group is what makes up a trend. Divergences are changes in trend that show stocks not moving as a group. It is difficult to know whether the signal means a change in trend or the appearance of a secondary trend. However, the divergence is a technical signal of market weakness. There are also times when divergence occurs and the stock market ignores a divergence signal and continues to move upward. The investor who is aware of trends has the advantage of knowing whether the market is strong and in what direction it is going. First the divergence signal, then the reaction, followed by a turn in direction.
The sequence can be illustrated by the events surrounding the October 1987 crash:
■ An all-time high for the Dow Industrials was reached in August.
■ The Dow Utility Average had been declining since April.
■ The Federal discount rate was raised, signaling a rise in interest
rates.
■ The reaction: The Dow Industrials drifted lower, down 200 points by October 19.
■ Finally came the turn in the trend, as the Dow Industrial Average fell 508 points.
SIGNALS
Signals can be confusing; a market trend can ignore what is supposed to happen and continue on its merry way. It is able to do this because it is a market of individuals making judgment calls.
Often, active investors wait for someone else to make a move. Groups form, believing the market will fall. Other groups form and take actions to prove the first group wrong. As the struggle ensues, buying or selling groups will gather and lose supporters until finally a majority of buyers or sellers emerges. The participants in this struggle will search out news and information to support their belief. If the news suggests their stand is incorrect, they will switch sides, and the market will move accordingly.
All the individual investor has to do is look for signals of a struggle
or weakness. Such signals will often appear in trend divergence. It can be
a divergence between the Dow Industrial Average and the Transportation
Average, or it might be a divergence between the Dow and an individual
stock.
The October 1997 Divergence
On Monday, October 27, 1997, the Dow Industrial Average fell 554.26 points—a new record one-day drop for the prestigious Dow (although not a record percentage one-day decline). Although some analysts believed it was doomsday, others believed the drop to be a short-term correction. There was divergence between the Dow Industrial and Transportation Averages during the few weeks before the record correction.
When the Dow Industrial Average is compared to the Transportation Average, it’s usually the transports that show weakness in relation to the industrials. In Figure we see a strong uptrend in the transports, while the Industrial Average is declining. Also, the increased volatility, with the market surging back and forth, was a signal of weakness.
NYSE Volume
A look at total NYSE volume for 1997 shows a cycling pattern, but not much in the way of a weakness signal. Although volume weakness appears near the end of August and again near the end of September, it seems to be similar to earlier weakness events that did not cause such significant corrections.
The highest volume spike was actually the day after the big crash: 1,201,346,607 shares changed hands on October 28, 1997, another new record for one day of trading. The Dow Industrials regained more than 337 points, with the Transportation Average moving up better than 95 points. The strength was there; it was just time to test the market.
What to Look For Look at the relationship between the Dow Industrials, Dow Transportation Average, and, to some extent, the Dow Utility Average. If they are close-
ly matching each other in direction and the volume is steady or growing, the market is strong. If the averages do not match direction or the volume is showing signs of weakness, the market is weak and could correct.
Secondary Opportunities
When corrections are short-term secondary trends, they present buying opportunities to the investor. If the Dow Industrials drops more than 20 percent or is down for more than two consecutive months, it is considered the formation of a bear market. The investor might want to wait for signs of stabilization as shown by less volatility and trend confirmation.
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