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OPINION

New year, new buy signal

New year, new buy signal
January 10, 2013
New year, new buy signal

The Dow Theory has given a new buy signal. You'll recall that it went to 'sell' in early November. I was sceptical at the time that this would lead to lasting damage, still less a full-blown bear market - see Sell signal (16 November 2012). Strictly speaking, one should not pick and choose between signals in this way, but my instinct was right. The S&P fell a mere 3 per cent to its lows following the sell signal, before beginning its recovery.

Dow buy signal

The new buy signal occurred like this. From their lows in mid-November, the US indices all experienced a strong rally lasting a month. Both the Dow Industrials and Dow Transports then pulled back by more than 3 per cent, another key element according to the Dow theory's precise rules, which you can read here. Finally, on 2 January, both Dow indices and the S&P 500 smashed above their previous rally highs, thereby switching the trend from downwards to upwards.

Previous signals

There have been three Dow-theory buy signals since the start of the current bull market. They led to gains in the S&P 500 index of 20.3, 9.8 and 10.2 per cent until the next signal, respectively. Over the long term, the average gain has been 23.6 per cent. According to Jack & Bart Schannep, the Transports' move to new bull-market highs above their 2012 highs is "a very favourable sign, as they often lead the way for the rest of the stock market".

Of course, just as sell signals can occur right near the lows - as in the case of November - buy signals can occur once bear markets are already under way. This happened in both November 2001 and in April 2008. In each case, heavy losses ensued. I see no parallel with the conditions around those occasions. Especially in the near term, this bull market looks good to go higher.

Nikkei's rising sun

I was delighted to see technical analysis make a cameo appearance in the chart-sceptical FT this week. The Markets column referred to the Nikkei 225's current overboughtness, given its recent relative strength reading of 85. While the Nikkei's rally may be stretched following its barnstorming rally of 25 per cent since mid-November, the same is not nearly true of Wall Street or even of the FTSE.

Still, there are some early signs of excessive enthusiasm creeping in. Bullish pundits in the US now number 51.1 per cent, compared with 23.4 per cent for the bears. That's a gap of 27.7 per cent. I tend to see a gap of 30 per cent as potentially problematic. However, this factor alone is not enough to ring alarm bells. In a strong uptrend, the reading can stay elevated for some time.

S&P ahead of highs

The S&P 500 and FTSE 100 are now knocking on the door of their bull market peaks, at 1474 and 6107 respectively. Hesitation at the old highs is only to be expected, as the experience of the S&P in 2011 and 2012 shows clearly. I am looking for 1500 and 6233 very soon.