Confirming a Market Turn

Last week, we discussed how the Dow Transports have not “confirmed the new low in the Industrials.” The Transports did not create a Dow Theory Sell signal. As we previously wrote: “Unless and until that happens, the excessive bearishness leads us to anticipate a strong bounce back rally.” So while waiting for a Dow Sell signal, we also were awaiting a follow-through confirmation day.

The “follow-through” methodology simply looks for a strong rally on any of the major indices of 1% or greater on better than the previous day’s volume. I like to see better than the 30-day average volume. This confirmation day ideally shows up in the 4th through 7th day following the first day of higher trading (post-reversal).

Tuesday’s action saw Nasdaq surging 2.2% in trading on 24% higher volume than the day before. That certainly qualifies as a confirming follow-through day. In our view, these are a reliable means of determining whether a reversal is a mere “dead-cat bounce,” or the start of a more lasting move.

Why does this method work? After the long sell off, anyone who wants or needs to sell has already done so. With supply drying up, the market finds an uneasy equilibrium. It takes very little additional buying to ignite a move up. Short covering often starts the process, than institutional buyers start accumulating shares, which draws the attention of the Technicians. Finally, the momentum players hop on board – and we are off to the races.

Additionally, despite the expected seasonal “Sell in May” weakness, the four-year presidential cycle continues to work in the Bull’s favor. As the nearby chart shows, the market has a tendency to rally, starting around June, in presidential election years.

That suggests to us that the next four weeks leading up to the Fed meeting and the Iraqi sovereignty handover could be especially volatile. Traders are expected to be positioning themselves in front of this event — and as this occurs, it would conform to our recent reversal rally thesis.

Tuesday’s action confirms our bullish stance from March 14th. We’re now looking for another follow-through day, on even stronger volume sometime over the next 5 trading days. It is probably too early to say that today is that day. But if we do get further confirmation, it would conform to our expectations for a new leg up, which we believe could last anywhere from two to six months.

Note: A much longer version of this was published at The Street.com (by subscription) here: Confirming Market Turns.

That column was a follow up to “Timing Market Turns.”