Today’s commentary will dive into Dow Theory and show some overlap with Elliott Wave. We will show the phase/wave counts for the last bear market and then make an attempt to label the current bear market. I will then turn to two breadth indicators that could show us when the stock market hits a bearish extreme. The problem, however, is that bearish extremes foreshadowed bounces between 2011 and 2020, but the market continued lower after hitting these extremes in 2008.
About the ETF Trends, Patterns and Setups Report
This report contains discretionary chart analysis based on my interpretation of the price charts. This is different from the fully systematic approach in the Trend Composite strategy series. In this ETF Trends, Patterns and Setups report, I am looking for leading uptrends and tradable setups within these uptrends. While I use indicators to help define the trend and identify oversold conditions within uptrends, the assessments are mostly based on price action and the price chart (higher highs, higher lows, patterns in play). Sometimes the chart assessment can be at odds with the indicators.
Basic Tenets of Dow Theory
I rarely use Elliott Wave analysis, but there are some aspects that tie in with Dow Theory, of which I am a proponent. In fact, The Dow Theory by Robert Rhea is a must reading for technical analysts. Originally written in 1932, Rhea synthesized the writings of Charles Dow and William Peter Hamilton into a coherent theory. These insights are still relevant because human nature, and hence the markets, do not change.
The stock market discounts everything. This means that all known information is already priced into the market. Markets quickly appraise new information and adjust prices accordingly.
The trend is in force until proven otherwise. Moreover, neither the length nor the duration of a trend can be forecast.
Dow Theory is not perfect and does not always work. This is true of any indicator. Successful trading and investing requires serious study and hard work. It is also imperative to assess the evidence without any bias. See what is really there, not what you want to see.
There are three primary movements: primary, secondary and short-term fluctuations. The primary trend is the long-term trend, which can last several months or even years. Secondary trends are reactions against the primary trend, such as an advance within a primary downtrend or a decline within a primary uptrend. Short-term fluctuations are price moves that last a few days and represent noise.
A primary bear market is a long-term downtrend that can be interrupted by sharp or seemingly significant counter-trend rallies. Rhea’s exact words were “important rallies”. Rhea notes that a secondary advance can retraced “33 to 66 percent” of the prior decline.
This is where Elliott Wave and Dow Theory overlap. There are five waves to an impulse decline (primary downtrend). Waves 1, 3 and 5 are down and in the direction of the bigger trend. Waves 2 and 4 are counter-trend advances that retrace 38.2 to 61.8 percent of the prior decline (Fibonacci numbers).
Primary bear markets are long-term downtrends caused by “economic ills” and there are three phases. The first phase is when traders give up on overpriced stocks that were bought at the end of the bull market. The second phase is when the economy actually deteriorates and business conditions worsen. The third phase involves selling of “sound securities, regardless of their value”. This third phase is also a capitulation phase.
Here we also have overlap with Elliott Wave and Dow Theory. In Elliott terms, the third wave stands out because it experiences the largest decline. This is the equivalent to the Dow Theory phase 2 of a primary bear market.
Getting back to basic Dow Theory, an uptrend is present when prices consistently hold above the prior low and exceed a prior high (higher lows and higher highs). A downtrend is present when prices consistently fail to exceed the prior high and decline below the prior low (lower highs and lower lows).
Double tops and double bottoms are “of little value in forecasting price movements and have proved to be deceptive more often than not”. The lesson here is do not go looking for a double bottom reversal in a downtrend.
A lot has changed since Charles Dow and Hamilton wrote for the Wall Street Journal. Dow penned his theories from 1889 to 1902 and Hamilton built on this from 1908 to 1929. Nowadays participants react to a plethora of news much faster, high frequency trading distorts daily price movements (and volume), and algorithmic trading has grown significantly. The markets are structurally different, but the nature of speculation has not changed, and will unlikely change in our lifetimes.
You can learn more about my chart strategy in this article covering the different timeframes, chart settings, StochClose, RSI and StochRSI.
Global Financial Crisis and Bear Market
The chart below shows the bear market from October 2007 to March 2009 with the phases, waves and two secondary rallies labelled. Phase 2 (Wave 3) stands out because it is clearly the largest (-47%). If you are interested in counting Waves and Phases, it is generally a good idea to find Wave 3 or Phase 2 first because they should really stand out.
Dotcom Bubble Burst and Bear Market
The next chart shows the bear market from March 2000 to October 2003. First note that Phase marking and Wave counting is subjective. In fact, Elliott Wave is a bit like economics. Ask 10 Elliotticians for their counts and you get 11 answers. We can debate the Wave counts and phases until we are blue in the face. The trend is all that really matters and the long-term downtrend did not completely reverse until the breakout in May 2003.
The Momentum Composite aggregates signals in five momentum-type indicators to identify short-term overbought and oversold conditions. This indicator is part of the TIP Indicator Edge Plugin for StockCharts ACP
Current Phase/Wave Counts
The next chart shows SPY with an 18.5% decline from the late March high to the mid June low. This is clearly Phase 2 (Dow) or Wave 3 (Elliott). And no, I am not going to subdivide this Wave. According to Dow, Phase 2 is marked by economic ills. According to Elliott, Wave 3 is the largest of the three down waves within a five wave sequence. This implies that we have a Wave 4 bounce and a Wave 5 decline ahead.
Regardless of the Phase or Wave count, the trend is down until proven otherwise. If looking for a potential support zone or target area, I would use the consolidation in Sep-Oct 2020 and the 50 to 67 retracement zone (blue shading). This targets a move to the 340 area, which implies another 10+ percent lower. Overall, a 50% retracement of the advance from March 2020 to January 2022 would involve a 27% decline from the January high and a 67% retracement would involve a 36% decline.
Extreme Oversold with Breadth Indicators
Bottom picking is a dangerous game because stocks can become oversold and remain oversold. The chart below shows the bear market from October 2007 to March 2009 with the Composite Breadth Model, the 5/200 cross for the S&P 500 and the percentage of stocks above the 200-day SMA for SPX. The Composite Breadth Model turned bearish on August 3rd, 2007 and stayed bearish until May 4th, 2009 (red/green arrows).
Regardless of the Phase or Wave count, the trend is down until proven otherwise. If looking for a potential support zone or target area, I would use the consolidation in Sep-Oct 2020 and the 50 to 67 retracement zone (blue shading). This targets a move to the 340 area, which implies another 10+ percent lower. Overall, a 50% retracement of the advance from March 2020 to January 2022 would involve a 27% decline from the January high and a 67% retracement would involve a 36% decline.
You can learn more about exit strategies in this post,
which includes a video and charting options for everyone.
The bottom window on the chart above shows the percentage of stocks above their 200-day SMAs moving below 5% in October 2008 and fluctuating around the 5% area for months (blue shading). The indicator did not get back above 10% until March 2009, which is when SPX bottomed. A move below 5% is the setup for a “stink” bid because this means almost all stocks are participating in the bear market. However, it does always NOT foreshadow an immediate bottom.
The next chart shows the period from late 2019 to June 2022. In the far left corner, notice how %Above 200-day SMA went below 5% for a little over a week (16-25 March) and then back above 10% at the end of March. This breadth extreme did not last long. The surge off the March 2020 low was historic and the Composite Breadth Model (CBM) turned bullish on May 29th.
The Composite Breadth Model will never catch an exact bottom. This is a trend-following model that turns when the evidence turns enough in one direction (up or down). Signals will be late and there will be whipsaws, but this indicator can keep us on the right side of the market, be it up or down.
The next chart shows the percentage of stocks above the 200-day SMA for the S&P 500, Nasdaq 100, S&P MidCap 400 and S&P SmallCap 600. The blue arrows on the SPY plot in the top window show when at least three of the four dipped below -10%. The last three dips were near a significant low (August 2011, December 2018 and March 2020). The fourth dip was in mid October 2008 and SPY did not bottom until March.
The next chart shows High-Low Percent for the same four indexes. High-Low Percent is the percentage of stocks making 52-week highs less the percentage making 52-week lows. The red lines are at -40% and the blue arrows on the SPY plot show when at least two of the three exceed -40%. Assuming no new highs, this means over 40% of stocks in the index are hitting 52-wk lows. This is excessive and these excesses marked lows in October 2011, December 2018 and March 2020. The exception, as usual, is the reading in October 2008.
A Bear Market Until Proven Otherwise
We are currently in a bear market, but nobody knows the path it will take, how long it will last or how far it will extend. Nobody. It looks like we are in Dow Theory Phase 2 and Elliott Wave 3, which are the most brutal of the bear market. Bear markets often end with some sort of capitulation where everything is sold and the decline accelerates. The news is awful when bear markets end as there seems to be no end in sight to the economic ills. At this point, the %Above 200-day SMA and High-Low Percent indicators have yet to reach extremes that could give way to an oversold extreme or potential stink bid. The Composite Breadth Model is decidedly bearish and I will be watching the Thrust Models for the first signs of strong buying pressure that could turn the tide (see last two windows). It could take a while.
Previous Commentary and Video
Wednesday Market and ETF Video (here)
Market Regime Update with Breadth Model and Yield Spreads (here)
Topics Covered in Tuesday’s Report (here)
- A Sell Everything Moment as 272 of 274 ETFs Decline
- Composite Breadth Model Update
- Baby with the Bath Water (90% Decliners)
- SPY Becomes Seriously Oversold (short-term)
- Utilities and Dividend ETF Succumb (XLU, DVY)
- Failed Breakouts and Short-term Breakdowns (XLV, MOO, XME)
- ATR Trailing Stop Triggers for Defense ETF (PPA)
- Materials Follow the Market Lower (XLB, RTM)
- Industrial Metals Reflect Economic Demand (DBB, CPER, PALL, PLTM)
- Gold Breaks Wedge Line
- Oil Remains Strong, but Energy ETFs Hit ($WTIC, XLE, XES, FCG)
- Agricultural Commodities Also Holding Up (DBA, WEAT, JO, CANE)
You can learn more about my chart strategy in this article covering the different timeframes, chart settings, StochClose, RSI and StochRSI.
