Is This Rally a Bull Trap?

[Ed note: This article was first sent to Slipstream Trader members on Friday, 19th March 2010. For more information on joining Slipstream Trader please click here].

Currently most charts are looking fairly positive and stable at first glance. If we have a look at US markets it is clear that the daily charts seem to be in strong uptrend with new highs being achieved in the index for this bull move. Moving averages are all positive and by default MACD’s look healthy.

So why worry? Well if you look under the bonnet at the market internals it sends a very different picture. In most of the trading sessions for the past 4 weeks the US markets have been trading far below their usual volume for this time of year. As Goldman Sachs JB Were mentioned during the week, the usual volumes for this time of the year are about 1.2-1.5 billion shares. Currently we have seen 9 of the past 18 days trade under 1 billion shares which shows quite clearly that there isn’t that much conviction in the current rally.

Also if we move our bird’s eye view of the market from a daily to a weekly chart I believe it shows a very different story and one that I think we need to sit up and take notice of.

Click to zoom in on Dow Jones Weekly Chart

Since the crash the market has retraced just over 50% of the extent of the fall. If the market is still under the influence of this primary bear move then you would expect to see heavy resistance in the 50% to .618% zone. Any resumption of the long term downtrend is likely to occur from this area (SELL ZONE in the chart).

Regardless of how good the short term fundamentals may look, I am very wary being too long in this zone. All the stocks we currently have in the portfolio have been bought with this in the back of my mind. I didn’t want to have a portfolio of stocks that was going to have an extremely high beta (I.e. By this I mean I didn’t want to have stocks that moved in line with the market with a high correlation. A beta of 1 means the stock moves with the market and is as volatile as the market. A beta of 2 would mean that the stock moves with the market but is twice as volatile).

Another point to make is that the momentum as shown by the weekly MACD is showing signs of weakening. I don’t really like the daily MACD as an indicator because it gives too many false signals. The weekly MACD on the other hand can give some good indications for when the long term momentum is shifting. If you have a look at the arrows in the chart you can see that the crossing of the weekly MACD with its signal line has often been right in predicting either a long sideways consolidation or the beginning of a downtrend. Even in the bull market there was only 2 times out of 6 where you would have said the crossing of the MACD was a bad signal.

The fact that the Dow is now retesting the highs from January means that we are really in the very high risk zone for falling over because I would expect to see some sort of false break of this high which could be the beginning of the down leg. If you look at the all time high in the chart you will see that the initial sell-off reversed and then had a false break of the high before finally falling over into the crash. This is often what happens at market tops and is known as a 2B or double top.

The more I look at the current situation the more convinced I am that this is what is going to happen in the near term and I think it is time to batten down the hatches rather than swing for the fences.

The VIX (volatility index) is currently at a level that it hasn’t been at since before the Lehman bankruptcy set off the final stages of the crash. This means that the market is very complacent at the moment and any shock could see a dramatic fall in a very short space of time.

I think the next few weeks in particular is when we should get a clearer picture about whether this rally is a bull trap or not.

Regards,

Murray Dawes
Editor, Slipstream Trader

Tagged as: bull, dow jones, downtrend, Goldman Sachs, JB, Lehman, MACD, rally, slipstream trader, VIX