BONDS SURGE AGAIN -- ANALYZING THE LONG-TERM TREND FOR SPY -- DOW THEORY STAGES -- SECONDARY MOVEMENTS -- EXPECTED RETRACEMENTS AND RESISTANCE LEVELS FOR SPY

BONDS GO BALLISTIC... Today's Market Message was written by Arthur Hill. John Murphy will return tomorrow. - Editor

The surge in bonds over the last seven weeks is truly staggering. The iShares 20+ Year Bond ETF (TLT) is up some 30% from its November low. On Tuesday, the Fed announced that it would consider bond purchases as part of its quantitative easing program. Nothing like having the biggest central bank in the world on your side. After a pennant consolidation in early December, TLT broke resistance on Friday and accelerated higher the last three days. This acceleration increased with a huge gap on today's open. Even though the big trend for bonds is clearly up, the iShares 20+ Year Bond ETF is clearly getting overextended after such a massive advance. Chart 1 shows weekly prices with a 14-period RSI moving above 80. Chart 2 shows daily prices with a 14-period RSI also above 80. TLT is overbought on two time frames. These overbought readings show both strength and excess. I dare say that this move is starting to look parabolic. It is difficult to pick a top, but history shows that parabolic advances rarely end well. At the very least, TLT looks vulnerable to a pullback or a consolidation.

Chart 1

Chart 2

BEAR MARKET RALLY OR NEW BULL MARKET?... Is this a bear market rally or the start of a big bull run? First, let's look at the weekly chart to assess the long-term trend for the S&P 500 ETF (SPY). Chart 3 shows weekly bars over the last 2 and a half years. SPY broke key support in January 2008 and recorded a new 52-week low in November. New 52-week lows are not usually associated with uptrends. In addition, the ETF remains below its falling 40-week moving average, which is the equivalent of the 200-day moving average. SPY bounced after becoming oversold in November, but the first bounce from a new low is not enough to reverse the downtrend. Uptrends require a higher high and a higher low. So far SPY sports neither. Moreover, the ETF is not even close to its falling 40-week moving average. On balance, the long-term trend remains down and the current advance is viewed as a bear market rally.

Chart 3

DOW THEORY STAGE TWO... Now let's look at this chart in Dow Theory terms. According to Dow Theory, there are three down legs, or stages, in a bear market. Even though these down legs are usually identifiable on the price charts, Dow Theory employs investor psychology and business conditions to identify these stages. The first down leg occurs with disbelief and marks a distribution phase. This is when the "smart money" distributes stock to the "not-so-smart" money. The news is still good, the economy is still robust and forecasters remain bullish. From Chart 4, I would label the October-to-March decline as the first down leg or first stage of the bear market. The second down leg occurs when economic conditions deteriorate, the news is bad and earnings estimates are reduced. The investment atmosphere turns negative as more pundits sour on the stock market. Hmm...this sounds awfully familiar. This second leg usually features the largest decline of three legs. Judging from current evidence, I would label the decline from May to November as the second leg or stage of the bear market. The third leg marks the capitulation phase. Valuations get lower, the news gets worse and buyers simply disappear as despair sets in. This often results in some sort of selling climax. From a Dow Theory standpoint, I do not think the market has hit the despair stage yet.

Chart 4

SECONDARY MOVEMENTS VERSUS PRIMARY MOVEMENTS... With the stock market advancing over the last 3-4 weeks, now is a good time to look at bear market rallies. How long might they last? How far might they extend? Dow Theory identifies two types of movements within the primary trend: primary movements and secondary movements. First, note that the primary trend is up in bull markets and down in bear markets. Primary movements are in harmony with the primary trend, while secondary movements run counter to the primary trend. In a primary bear market, advances would be deemed secondary and a lower high would be expected. In other words, secondary advances would be expected to fall below the prior high. Furthermore, Dow Theory suggests that secondary movements often retrace between 1/3 and 2/3 of the prior primary movement. This jibes with the Fibonacci Retracements Tool, which features the 38% and 62% retracement levels. Chart 5 shows the S&P 500 during the prior bear market. There were three distinct declines (primary movements) and three counter-trend advances (secondary movements). These secondary movements retraced 44-60% of the prior decline. Even during an extended bear market, there were significant counter-trend rallies. Chart 6 shows the same S&P 500 with the ZigZag feature and its retracements. The yellow highlights show the exact retracements of the secondary movements.

Chart 5

Chart 6

WHERE TO EXPECT RESISTANCE... Based on the prior bear market rallies, the Fibonacci Retracements Tool and Dow Theory, a bear market rally can be expected to retrace 1/3 to 2/3 of the prior decline. Chart 7 shows the Fibonacci Retracements Tool with highlights between the 38.2% and 61.8% marks. Taking 50% as the base case, a bear market rally could extend towards the 110 area. The red line shows an extrapolation of the falling 40-week moving average. This key moving average could easily reach the 110 area in January and also mark resistance. Why the 40-week moving average? Chart 8 shows SPY with the 40-week moving average in the prior bear market. This key moving average acted as long-term resistance throughout the bear market. Notice that the ETF failed at this key moving average after two secondary rallies.

Chart 7

Chart 8