This article explores market timing by examining three charts of the Dow Jones Industrial Average for a clue as to how charts can be useful to signal a market top or bottom. Even just sticking with the basics pointed out in these charts, you should have a better idea of when it is time to re-enter the markets after a slide or whether it is time to exit positions and raise more cash near a market top.
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What I just suggested is heresy to many people who don’t believe you can time the market. To them I say, I agree with you. You can’t possibly know everything that will occur and therefore how the market will be affected. So why am I writing on this as our special subject? I am writing this because you don’t have to time the market. You have to be able to anticipate what the market participants will do and position yourself to benefit from that. You can, in fact, get a really good idea of how market participants will behave. Let me show you how.
The first chart we will look at is a weekly chart of the Dow Jones Industrial Average (DJIA) over the last four years:
Now, I am an experienced chart reader and the first thing I see when I look at that chart is a mess! I mean, there are over 200 candlesticks on that chart and there are squiggly lines. On top of that, I organized that chart with three highlighted areas on the left half of the chart and then the right half is that horrible fall from the October 2007 top until the March 2009 bottom. Ouch!
The thing about this chart is to only look at it for what you can learn to trade with. If you can use something in the chart to determine how the market participants are likely to act, then you can effectively trade for profits, or at least ensure you don’t lose your assets to a market decline.
So, looking at the chart again, we see the three highlighted areas on the left. All of them show a distinct movement from the lower Bollinger Band up to the upper Bollinger Band before the move would fail and a short correction ensued. If you want to see them in a little more detail and you want the secret that could have allowed you to exit before the corrections began, take a look at the next chart. [Don’t worry, we will come back to learn a bit more from this first chart when we get done zooming in].
The second chart takes a piece of the four year chart and zooms in to see if there are simple indicators we could have used to keep us out of harm’s way:
In the above chart there are two periods delimited by arrowheads. The first period is a normal healthy uptrend depicted as the leftmost box in the previous chart. It lasted for a long time but had some movement up and down in an otherwise bullish move. Note that once price moved above the 200-Day Moving Average (DMA), it stayed above that level, pulling back to it once and then continuing higher. When price finally moved below the 200-DMA by early June 2006 it couldn’t initially rally back above the 200-DMA and had to form a double bottom which began the second bullish move.
The second bullish move is the most frustrating period for a reversal specialist. In fact, I look at all sorts of market data, sentiment, indicators, and other signs of the actual behavior of market participants to attempt to gauge when that behavior will change. I am a reversal specialist. For me, the most frustrating time isn’t when the market is moving up and down or even straight down. It is when it moves continuously up without any significant corrections. That is what happened from July 2006 through February 2007. It was an eight-month period of time in which the Dow Jones Industrial Average didn’t experience so much as a two percent correction. That hadn’t happened in nearly fifty years.
Since I am trading to take advantage of market changes (reversals), it was a frustrating time. Sure, you can sit in your long positions and the positions keep getting bigger. But how will you outperform a market like that without adding leverage or taking on undue risk. That is what is frustrating. It is like being becalmed at sea and all the other boats are also becalmed but you want to beat them to port. It doesn’t really matter how good a sailor you are without any wind.
Do you want to know what I did during that time? I kept positioning for reversals that didn’t amount to anything. Until I finally saw something I liked. I am going to share that something with you because you may have the opportunity to use it to trade an index ETF or a stock, etc.
Take a look at that second uptrend in the chart above, which is the same uptrend in the second yellow highlighted box in the first chart. Looking at the RSI line below both periods, you will note that it starts from a low position moving upward but the latter part of both periods is typified by a sideways moving RSI or even a bit downward. When you see that, it is known as a contrary indicator because it is moving contrary to price. I am always looking for contrary indicators. An important indicator when RSI was moving sideways or declining turns out to be the MACD. If you look at the histogram for the MACD, it has bars that grow and diminish in size and are either positive (green) or negative (red) in value.
If you focus on when the MACD moved from green to red with RSI moving sideways or lower after/during an uptrend, you know that the uptrend has finally failed. MACD is considered a lagging indicator, but in the second uptrend it clearly warned that the uptrend would fail. Because of such a simple indicator, I was able to position subscribers to lock in gains and make an additional 20% in gains over a matter of days instead of losing the majority of gains achieved during that eight month run.
Let’s take a look again at our first chart of the Dow again. Looking at the right side, we notice that each time price broke down below the lower Bollinger Band for at least two consecutive candles (weeks), the Dow would rally, only to fail and repeat itself. This continued for a predictable period of time.
Why do I say it was predictable? It was predictable because when the bottom was finally put in, we once again had a contrary indicator. RSI was moving higher as price formed a lower low. In fact, the MACD also was moving higher at the same time and the MACD histogram only moved from green to red at the bottom and then moved immediately back to green signaling the all clear. Once price moved up to the 200-DMA and then only retreated to the 20-Week Moving Average, it was bye-bye as the market moved strongly higher.
Let’s take a look at our final chart and see if we can learn what the market is likely to do next. This is a 1-Year chart of the DJIA:
When we first look at the chart we notice it is somewhat proportional on the left and right, with the downside action on the left bottoming in March and then overall rising since then. That rise was halted by running into the 200-DMA then retreated for four weeks down to the 20-Week Moving Average (note that the 20-Week moving average is roughly equivalent to the 100-Day Moving Average). From that point on it has been relatively smooth sailing. Price is trading comfortable between the 50-Day Moving Average (yellow line) and the upper Bollinger Band.
Things look quite bullish at the moment. So, what else can we determine from the chart? We note that RSI has been moving higher for a year. That is correct. Since the downtrend was still underway and the market experienced the dramatic sell-off, RSI was already predicting the bottom. What about the MACD? MACD crossed up and into its signal line at the bottom and then up and over (with a corresponding histogram going from red to green) within a couple more weeks. The next week price closed above the 50-Day Moving Average and an uptrend was confirmed.
What is the market going to do now? That is, of course, the question market participants always want an answer to. Reflecting on what we have learned, what don’t we know? We don’t know exactly when the market may roll over. We do know what to look out for.
We will watch price action to be divergent with RSI. If price continues to move higher but RSI begins to move lower, we will know that the end of the uptrend is coming. If MACD goes back below its signal line, i.e. the MACD histogram goes from green to red; we will know the market is going to top. We can actually monitor the size of the green bars and the best signals are generally when the green bars get large and then get regularly smaller telegraphing the change from green to red.
So what will all of us begin to watch for together? We will look for RSI to reverse at some level. If there is a corresponding MACD crossover, we will want to exit our long positions and will buy puts and go short at some point.
The charts we have been looking at are in weekly increments. We rely on them for a long term perspective, but you can get even more precise to enter/exit trades by switching to daily charts. If you would like to see how we do this, write me and we could do some of that next week.