IS the economy smarter than the market? This is the key question and the answer determines how we manage investments and how we trade the market. With unemployment levels not seen since the Depression, shuttered shops, businesses that will not reopen, and business that will reopen but not be able to recover from the cash flow drought and collapse within months, the economic outlook looks grim.
On the other side of the equation, the US financial markets have turned in their best monthly performance in decades. The Dow has recovered 35 per cent since the low in March. The old trader's axiom tells traders to trade what they see on the chart rather than what they believe. Another boost to the market has been given as President Donald Trump disbands the Covid taskforce and gives preference to the Dow rather than warnings about an increasing death rate.
The big danger for investors is a violent snapback where the market rapidly retreats to match the economic outlook. The alternative that Mr Trump is backing is where the economy rises to catch up with the market - back to full business by the end of May. Some politicians would have us believe the economy will catch up to the market with a snapback. Others believe the market will correct back to the struggling economy, and this underpins the dead-cat bounce analysis.
A dead-cat bounce is a market fall followed by a weak rebound which is then followed by a longer continuation of the downtrend. The 35 per cent rise in the Dow cannot be described as a weak rebound. The 2008 Global Financial Crisis had an extended dead-cat bounce. The Dow recovered 26 per cent and then resumed the downtrend for the remainder of 2008. It's this extended dead-cat bounce that haunts investors.
President Trump believes the economy will follow the market lead and the Dow chart allows us to assess this belief.
The Dow chart is dominated by a single horizontal support line at 23,500. It is not a level that has been successfully tested and retested. The dip below this level in December 2018 and the rapid fall through this level in March 2020 suggests it is not a strong influence on the market. However, it's the best technical reference point available because the rapid rebound rally has paused near this level.
Throw a ball into the air and it decelerates as it approaches its apogee, where it appears to pause just prior to reversing direction and accelerating downwards. It's a perfect analogy for the current situation with the Dow. A sustained fall below 23,500 is bearish and has the potential to retest 2018 lows or the 2020 lows.
Investors watch for evidence the support level can hold and provide a base for a strong rebound and a new uptrend. The behaviour of the Dow around this support level provides the critical information about the direction of the snapback.
Parallel with this outlook is a bearish counterpoint, measured not by the rise in unemployment, but by the collapse of the price of oil needed to drive a modern economy. The crash below zero never made it as far as the petrol pumps but it is a harbinger of a much-slower economic recovery. The Nymex oil chart suggests higher prices are on the way, but these remain very very low by historical standards.
Any price rise is capped first by the downtrend line which has a current value near US$31 - a price last seen 20 years ago. The oil price must move above the down trend line before a new uptrend is established. Any trend breakout from such a severe downtrend is most likely to be preceded by a period of consolidation between the US$10 and US$20 levels.
Oil has a well-defined characteristic. It trades between strong trading bands, around US$11 wide. The first of those resistance levels is near US$20 and the second near US$31. The oil chart shows a series of formidable resistance barriers that need to be defeated before a new uptrend can develop. This confirms the continuation of low oil prices in a slow economy.
Private investors have a giant advantage over their professional institutional peers. Private investors do not have to make a decision every day, or every week. They can choose to stand aside from the market and wait until a clear direction is established. These contradictions between the economy and the market make a great spectator sport. It's too early to know which side will be the winner so cautious investors will stay on the sidelines watching for the snapback.
- Daryl Guppy is a financial technical analysis specialist, an equity and derivatives trader, and an author. He has developed several leading technical indicators used by investors in many markets.
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