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Ready for a nasty reversal of fortune?
Technical traders say reversals are not just rare -- they're also among the most reliable trading signals. Here's what that could mean for the months ahead. Plus: Dow 577? Richard Russell thinks the bear market could last until 2008.
By Jon D. Markman
Those of you who watched college sports last weekend know that one of the most exciting plays in football is a reverse. In a classic example, it happens when the offensive team makes the defense think it is running left, but out of the blue, a running back crosses behind the quarterback, takes the ball and streaks toward the goal in the opposite direction.
The stock market has its reversal plays, too, and they are among the most rare and dramatic of technical patterns -- as we saw in July and October to the upside, and might soon see again this month to the downside.
An outside reversal day occurs when the high point in the trading of an equity or a broad index exceeds the previous days high and the low exceeds the previous days low, and the close is at the bottom or top of the range. Stock charts in which each days high, low and close prices are drawn in the shape of a vertical bar thus show that the reversal days action extends above and below the prior days action, which is why technical traders call them outside bars.
If the stock or index was trending down during the weeks prior to the outside bar, then an outside reversal bar that closes at or near the top of the day is considered very bullish. It means that sellers gave it their best shot that day, but were swamped by buying pressure and laid down their arms. Likewise, if the stock or index was trending up during the prior weeks, an outside reversal bar that closes near the bottom of the day is considered very bearish. It means that buyers gave stocks a final hard push but were overwhelmed by selling pressure.
These patterns occur so infrequently and work so persistently that many pros say they will trade them on blind faith. If you look at recent history, you can see why:- An outside reversal day on July 24 this year marked the end of the midsummer collapse in the Dow Jones Industrial Average ($INDU). On July 23, the Dow industrials closed at 7,702 after hitting a low of 7,591 and a high of 8,008. The next day, the Dow industrials closed at 8,191 after hitting a low for the day at 7,490 and a high of 8,243. There was a 701-point difference between the low of July 24 and the close -- a fantastic outside reversal that launched a massive rally into the end of August.
- The next outside reversal day for any index occurred Oct. 10 to mark the reversal from the bear-market low in the Nasdaq Composite ($COMPX) toward the recent rally. On the Nasdaq, the low on Oct. 10 was 1,108, the high was 1,166 and the close was 1,163. That was an outside reversal to Oct. 9, when the high was 1,136, the low was 1,112 and the close was 1,114. The tech-heavy index never looked back from that reversal bar, advancing 400 points in a month and a half.
In either of these cases -- and there are many more examples with individual stocks -- big bets in the opposite direction of the trend were the correct trade in the days following the big one-day reversal.
Will bears regain control?
Now, fast-forward to the first week of December, and you can see why active traders were glued to their screens on the first business day of the month as a wild session unfolded. Every day since the early October turnaround, price action in each session was contained within the price action of the prior day. But on Dec. 2, the big indexes reached much higher levels than those of Nov. 29, when positive news out of Wal-Mart Stores (WMT, news, msgs) drove prices; the indexes promptly plunged to levels much lower than those of Nov. 28, when a poor economic report dampened trading.
This action set up the potential for one of those uncommon one-day reversal bars. To avoid that outcome, bulls needed to push the Dow Jones industrials above 8,900 or so and the S&P 500 Index ($INX) to around 940, leaving the closes in the middle or upper half of the days trading. In that event, it would look like just another day of trading: a down day, perhaps, but nothing earth-shaking.
Bulls and bears fought a pitched battle, but enough buyers emerged by the end of the day to blur observers view of a picture-perfect outside reversal day. The S&P and Dow traded off but avoided the worst sort of reversal bar -- one that closes at the days low.
Is that the end of the game? Not by a long shot, for bears may now be emboldened in their quest to sweep the opposite way of the recent trend. If you want to get on the inside of this outside action over the rest of the week, keep an eye on this weeks closing levels; outside reversal weeks are considered even more prescient of future action than reversal days.
We already know that Mondays open marked a high that was higher than the previous weeks high for the three major indexes. If any or all of the indexes close below their lows of last week (8,634 for the Dow, 912 for the S&P 500 and 1,441 for the Nasdaq Composite), significantly lower prices could be in store for the remainder of the year.
Richard Russell: Still a skeptic
Speaking of reversals, I spent an intriguing hour last week talking with Richard Russell, the granddaddy of newsletter publishers. Now 78, considered a saint by his many allies and a crackpot by foes, he has written about stocks continuously since 1958 in the Dow Theory Letters and has numerous coups to his credit, including an outrageous and accurate forecast of a new bull market in his inaugural year and a famous call of the end of the 1973-1974 bear market in December 1974.
Dow Theory, invented in a series of editorials by the founding editor of the Wall Street Journal in the early part of the 20th century, essentially suggests that bear markets end and bull markets begin when extreme pessimism produces extreme values in the shares of the nations largest companies. The foundation for much of what is now known as technical analysis, the theory also suggests that advances or declines by the 30 stocks in the Dow Jones Industrial Average are legitimate only if confirmed by advances or declines by the 20 stocks in the Dow Jones Transportation Average ($TRAN). The idea is that the industrial companies make things and the transportation companies deliver them. If they arent in synch, somethings wrong. And right now, in the microclimate of December 2002, he thinks sluggish action from Nov. 6 to present by the transports are a non-confirmation of the recent surge by the industrials.
Pan out to the bigger picture, and Russell, a bombardier in the Army Air Corps during the Italian campaign of World War II, says he believes the market today is every bit as risky as it was in 1996. That year, he told subscribers-- way too early, as it turned out -- that he was pulling out of stocks. From that point through 2000, he said, the market broke every rule on the upside as it catapulted to extreme heights and is now in the process of breaking every rule on the downside.
He said he would remain a skeptic until he can see the public turn dead bearish and make values appear in stocks. That will occur, he believes, when the average price-to-earnings multiple of Dow stocks sinks to 7, the average dividend yield rises to 6%, and friends call him nuts for turning bullish. He wont offer a precise time or price target for that moment, but notes that the 1921 bull market started at Dow 63 and ended in 1929 when the Dow hit 381. Three years later, after a crash and economic depression, the Dow had plunged to 41. If the same scenario were to play out today, he says, the Dow could sink beneath the 577 level at which the bull market began, in his view, in 1974. Most bear markets last a third as long as bull markets, he says, so if you measure the age of the bull at around 25 years then the bear could last eight years -- or until 2008 or so.
The catalyst? Youd have to have China become an almost unbeatable world economic and military power, exporting deflation and pushing down the economies of the West, he said.
Sounds impossible to me, but I suppose stranger things have happened. After all, if outside reversal days and weeks have value, perhaps we should take note that January 2000 was a bearish outside reversal month that has not yet been itself reversed by a bullish outsider cousin.
Fine Print
To read more about Dow Theory, visit Russells Web site. In particular, read the free historical essay on the concept here: ... I received all sorts of nastygrams on Nov. 20, following a column that called into question the valuation and earnings quality of small-cap military software services contractor PEC Solutions (PECS, news, msgs). Said one reader: Most of you guys looking for the next Enron (ENRNQ, news, msgs) or WorldCom (WCOEQ, news, msgs) don't want to say or write anything credible, you're just looking to sling wobbly arrows at good, clean companies. Bulls promptly shot me down by driving the stock up 15%, but shares have fallen back to Earth in the past few trading sessions following valuation downgrades by analysts at Raymond James and J.P. Morgan. Theyre now trading below the level of Nov. 20.
While Jon D. Markman cannot provide personalized investment advice or recommendations, he welcomes critiques and comments at supermodels@jonmark.com. At the time of publication, Markman was neither long nor short any securities or indices mentioned in this column.
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