FTSE's shallow decline
Since their highs of Friday 14 September, America's S&P 500 index and our own FTSE 100 have drifted gently sideways and lower. They have been joined just lately by the Dow Jones and Nasdaq 100 indices. The latter dropped 1.9 per cent from peak to trough on Tuesday 25 September, its biggest one-day decline since early July.
Nasdaq's hard sell
As a bull, I have to say that I am pleased about this. Most of the indices were looking nearly overbought on their daily charts as of Monday 24 September. The Nasdaq was sporting a relative strength index reading of around 70 per cent, as it had been for some days. It is hard for equities to enjoy a long-lasting rally when they are already looking stretched. A dip is necessary to set up further gains.
How far do the markets need to come off in order to give them a decent springboard to advance? I would regard a retreat to the 21-day exponential moving averages as perfectly adequate. A slightly deeper retreat to the 55-day EMA would be better still, really. In the case of the FTSE 100, this line currently sits around 5757 and 13178 for the Dow. A rally beginning in that neighbourhood would be an absolute peach of a buying opportunity in my book.
Dow QE2 lift-off
There should be little doubt when such a rally gets under way. Previous bounces in the Dow during QE periods have started with a bang. Once QE2 was formally announced in November 2011, the market sold off down to around its 55-day EMA and then exploded higher by 2.4 per cent in a single session. Put simply, a strong day's buying where the price closes at or near its highs would be enough to get me long again.
Terry Garside emails to ask whether I am concerned by the negative divergence on the Dow's weekly relative strength index. Negative divergence is where the price of an index reaches a new high for a particular move, but its momentum indicator does not. Almost all major tops in the market over the past eighty-four years have been accompanied by negative divergence.
Dow's negative divergence
The Dow hit a post-2009 high of 13,653 in the week ending 14 September, accompanied by a weekly RSI reading of 65 per cent. However, the peak RSI reading for the bull run was 77.6 per cent back in February 2011 - 71 weeks ago. Since then, the index has made three successive new peaks in price, each of which has been accompanied by a lower weekly RSI reading.
In my study of the broader-based S&P 500 index, I found that momentum generally peaks at 77.8 per cent some 65 weeks ahead of the peak in the market index. At the market's peak, the average RSI reading has been 67.2 per cent. On these metrics, all the conditions are right for a major top. But I'll happily put money on the fact that we don't get a top now. The money is being freshly printed as we speak and will be flooding into equities near you shortly.
