Stock Market Literacy: Your Best Protection Against a Changing Investment Landscape

By Ryan McGuire
for Gold Avalanche

Some of you may already be short the market. It may not exactly be time to be short, but it may be time to pick up one of those funds that inversely tracks the performance of the S&P 500. It may also be the time to start looking at short term bonds and gold. However, it may not be time to buy them ... yet!

Here's why

I read a book called 'essential technical analysis' by Leigh Stevens which digs into the fundamentals of Dow Theory. Intrigued, I decided to learn the theory as inside-out and backwards as I could (I'm not the most knowledgeable computer in the lab, but I'm determined) to see if it still holds any water in today's markets. A lot of people out there in the financial world seem to think that the Dow Theory is outdated, given the nature of the economy today. I have found these views to be left wanting.

This is my take

I look primarily and peak divergence on lows and highs, which is an off-shoot of Dow's main theory. With this view in mind, the current multi-year state of the Dow/trans relationship is this:

In 2008, both indexes were hitting all time highs, but then some major peak divergence showed up when the Dow hit new all-time high (week of Oct 5, 2007) not confirmed by Trans. This brought the averages to new intermediate lows. Then, a false trend reversal signal was given. Both indexes made new lows, then The Transportation index made higher lows while the Dow continued to make some lower lows. Finally, the transportation index  hit a new all time high, but this was not confirmed by the Dow.

What came next was the 2008 crash, and the March 2009 bottom

Fast forward to 2011. The transportation average hit another all time high, but the move was not confirmed by the Dow. The intermediate divergence that followed, where the Dow hit intermediate highs not confirmed by the transportation average, gave way to the 2011 sell-off. The lesson here is that the divergence wasn't severe enough to warrant the 'this is the end' type fear of the financial blogs.

The bottom of each bear market came when both indexes confirmed a new intermediate low together, after the initial bear market low. Other wise, we can look to peak divergence signaling that the bear remained in tact.

This year, it looks like the transportation average can't build any steam, while the Dow is flirting with new all time highs ... and this is despite economic fundamentals! How insane is that!

The lesson today is that if the Dow hits those new all time highs, it will be our chance to really load up on the inverse funds and buy into bonds before the next big crash, as long as the transportation average doesn't follow suit. If a signal is given that a trend reversal is at foot, we should be well-cautioned to heed its warning.

Of course, the movement of the indexes will let us know if this idea of another big crash changes. We could be in a 2000-2002 type of market where everything erodes in fits of volatility. Thanks to HFTs though, it's becoming easier to spot divergence.

To me, the weekly charts are starting to look like the old daily charts and daily charts are starting to look more like the old minute charts in terms.

As for right now, if the transportation index holds above 4,900 (the previous cycle low), and the Dow fails to break through its previous cycle low at 12,101 on a closing basis, the current mini-trend down can be considered basically spent.

But until both averages make new highs together, continued volatility should be the norm.

Once again, the real scary stuff will happen if the Dow rallies again to a new high and the transportation index fails to confirm the move (or vice versa) followed by an opposite move a few weeks later - just like it did in 2007-2008, and 2011.

For Example, if the Dow hits an all time high in the next couple of months, and the transportation average fails to confirm that move, anyone who isn't buying bonds or holding a majority of their portfolio in short positions and cash is going to get wiped out, because the move down will be significant this time.