The Dow has been too murky to trade

It has been some  time since I covered the Dow. The main reason is that the chart patterns were very confused (at least they were to me). What appeared to be the start of a major leg down off the 19 May high actually turned out to be something else – and that has only become apparent to me in recent days. So today, I believe I have a better handle on the patterns now forming.

Incidentally, I have noted before the yawning gap between the stockmarket and the real US economy. When the economic news was poor, stocks got a boost. It was a case of bad news equals good. Investors were led to believe that the Fed would be less inclined to raise interest rates, which would have a bullish impact on stocks.

Both consumers and companies have been adding debt at manic levels as their borrowing costs were low. But even a small increase in loan repayments could disrupt that. In the media, there have been ample recent scare stories of calamity ahead, for house prices as well as shares. This barrage of gloom-and-doom articles almost assures that if it does happen, it will not be on the time-scale envisaged!

One example of this bad- equals- good effect was vividly shown on Tuesday when the US Treasury released a raft of economic data. With eight of the ten components falling, the data pointed to weakness in the second half of this year. Earnings fell 10 points, followed by current job openings and company expansion (down 5 points). Here are some of the other figures released this week:

NFIB Small Business Optimism Index

Consensus: 98.3 Actual: 94.1

Eight of the ten components fell, pointing to weakness in the second half of this year. Earnings fell ten points, followed by current job openings and company expansion (down five points).

The small business sector is usually the first to signal a downturn – and this data is certainly not supportive of the idea of an expanding economy.

Retail Sales

• M/M change consensus: up 0.3% Actual: down 0.3%
• Less autos consensus: up 0.6% Actual: down 0.1%
• Less autos and gas (petrol) consensus: up 0.6% Actual: down 0.2%

Are US consumers spending like gangbusters in this ‘recovery’?

Import and Export Prices

• Export prices year to June – down 5.5%
• Import prices year to June – down 10%

Has deflation been conquered by the Fed and is CPI (consumer price index) heading towards their desired 2% target when they say they will raise rates?

Redbook (chain store sales)

• Prior – up 2.0% Last month – up 1.4%

Business Inventories

• Consensus – up 0.2% Actual – up 0.3%

Ratio of inventories/sales is pushing 1.36 – a multi-year high. Are final sales booming? Is this indicating an uptick in inflation?

I have put on my rose-tinted specs and still do not see a bullish picture for the US economy and inflation. But hey – no problem for stocks, they kept up the rally anyway. We know that the economy is not the stockmarket, so let’s turn to the charts.

Why the Dow’s worth trading now

In May, as the market declined, I suggested that we might see a five down – and the early indications were good with the market dropping hard:

Dow Jones spread betting chart

My first guess was that wave A was wave 1, wave B was wave 2. When the market moved below the A wave low on Monday 29 June, that set up the real possibility that we were in wave 3 of a five down. To confirm my suspicion, I needed to see the very sharp decline which is the hallmark of a third wave.

But when the market made a large positive-momentum divergence a week later – and then sharply recovered – I knew my third wave idea was in big trouble. That was when I decided to just stand aside and watch.

When the market moved higher to close the gap, that raised the odds much higher for a new all-time high up ahead. This was an alternative outcome I had considered for some time.

But with that spike low of 5 July, which I could see was a major low, I went back to the long-term daily chart to find possible tramlines – and found a superb pair! The 5 July low had given me the perfect touch point for my lower tramline – with the added benefit that now I have an upper target: on the upper tramline.

Dow Jones spread betting chart

If the market could move up to my upper tramline in the 18,500 – 18,600 area, that would complete a major five up on the weekly chart.

So in this scenario, what are the short-term prospects? The rally off the 5 July spike low is in three waves so far. My wave 3 has the typical long and strong look of a third wave and I expect a dip in wave 4 leading to a further rally in wave 5.

Dow Jones spread betting chart

Let’s see if I can pinpoint where wave 4 will appear. On  the hourly chart and I have a nice small tramline pair working. But the market has rapidly lost momentum as it climbed into the Fibonacci 78% resistance.

A break of the lower line would likely set off the start of wave 4 down.

Dow Jones spread betting chart

So now I have a clear roadmap. Of course, this could be negated if the market does start to pay attention to the deflationary global scenario now unfolding. And my eyes will be on the outcome of the Greece/EU war, and whether there will be any debt write-off. If German resistance can be overcome, that would open the floodgates to more unpayable sovereign debt being next in line. The stakes could not be higher.