We spend most of our time looking at our various valuation models in search of stocks that are cheap. We do, however, watch the price trends of stocks and the major indices, especially in times like these when we believe prices have become so disconnected from valuations.
The chart at the right (click to enlarge) shows the Dow Jones Industrial Average (DJIA) for the last twelve months. You will note that we are also showing two moving averages: a 200 day (dark line) and a 50 day (light line).
The 50-day moving average, in our minds, is the key technical indicator that most traders are watching. With the benefit of hindsight, the reason is simple: the 50-day moving average has been a key level of resistance for the overall market since last June.
Look at price movement of the DJIA during May of last year. It was at this point that the DJIA fell through its 50-day moving average. The chart also shows the market's feeble attempt to climb back above the 50-day moving average in late May and again in early June.
The market then fell sharply before attempting to make a bottom in mid-July. At that time, it turned higher and made a valiant attempt to pierce the 50-day moving average during August and September. Unfortunately, the DJIA failed in its attempt to get through the 50-day and once again it sold off sharply in October.
After the sharp sell off, the market appeared to find a bottom in November and December at around the 8000 level on the DJIA. But again its attempt to meaningfully pierce the 50-day moving average in December and January ran into sellers, who once again drove stock prices into a free fall that finally reached the 6600 level on the DJIA.
The DJIA is now attempting at least its fourth try in the last year at getting out from under the selling pressure that has come each time the market has tried to get through the 50-day moving average. The chart shows that the recent rally has once again brought us very close to the 50-day moving average. The actual level is near 7500.
We think the odds have dramatically improved that a bottom is near for these reasons. Chart reading is not an exercise in quantifying valuation. It is an exercise in measuring emotions, particularly at its extremes. In our judgment, the DJIA has kept breaking below its 50-day moving average at critical levels because of negative momentum, but also because the majority of investors did not believe the Fed and the US Government were doing enough to deal with the credit crisis.
There are now at least three major programs that either are now or soon will be in place to deal with the capital of the banks, the freezing up of consumer and corporate loans, and the real estate fiasco. The latest plan was the announcement this week by the Federal Reserve. Fed chief Ben Bernanke announced that the Fed will buy up to a trillion dollars of US government bonds, mortgage agency notes, and mortgage backed securities. These purchases should push not only mortgage rates lower, but also interest costs for corporation. Combine all this with the bailout of the Auto industry and the stimulus plan and the US government has now gone a long way toward putting a floor under the economy and we believe under the stock market, as well.
In light of this massive undergirding of the economy, we believe that the probabilities for upticks in both economic growth and corporate profits have grown for the latter part of 2009. If this is the case, the odds that a decisive bottom in the Dow Jones is near have increased. This argument is augmented by the fact that stocks are down over 50% from their highs. Indeed, one could say that we are floating in a sea of value. All we need is some sort of good news to propel stocks to much higher levels.
If the market is able to fight its way through the 50-day moving average many of the persistent sellers of the last year will become buyers and add staying power to the beginnings of a new bull market.
