Watching the Transports

A bearish engulfing candlestick pattern is a reversal pattern, occurring at the top of an uptrend. The pattern consists of two candlesticks: 1) a smaller bullish candle (Day 1) followed by a 2) larger bearish candle (Day 2). The bullish candle real body of Day 1 is contained within the real body of the bearish candle of Day 2. On day 2, the market gaps up (typically interpreted as a bullish sign) however, the bulls run out of gas and do not push price very far before the bears take over reversing price down, not only filling in the gap from the morning’s open but also below the previous day’s open. A completed pattern warns of a high probability (at least for the short term) the uptrend is over. The larger the candle body and volume on day 2, the higher the probability of a reversal.

Taking a look at the weekly chart of the Dow Jones Transportation stocks you can see last week closed with that same bearish engulfing candle. Unfortunately for the bears, while last week’s candle did engulf the prior week, it was not overly large. In addition, the weekly selling volume was just slightly above average, nothing out of the norm. If you look to the immediate left at the most recent prior peak in November of last year, it too formed a bearish engulfing pattern where the gulfing candle was not only huge but was confirmed with excessive selling volume. Notice what happened immediately following. This is why you need to take notice when these patterns appear

I have been saying for a couple of weeks the market looks tired but was not yet telling us we had reached the end of this reversion to the mean bounce from last Christmas eve. With last week’s close though, the transports have thrown out the yellow caution flag warning long-term investors to likely expect further selling pressure and short-term traders to cash in their chips or at least tighten stops.

The Return of the Doji

The “doji” (meaning the same or no change in Japanese) can be one of the most important candlesticks when viewing charts. It indicates that buyers and sellers are at equilibrium, a state of indecision and balance. Equality never persists as eventually one side will win, as such investors should desire to be on the side of the winner. When doji’s appear at the end of an extended trend (either up or down) they have the potential to be a significant warning that the near-term trend may be ending. The Japanese (who created candlestick charting) say that whenever a doji appears, investors should always take notice.

The doji is formed when price opens and the closes at or very close to the same level. In Candlestick charting, this essentially creates a “cross” formation. As the illustration below shows, doji’s take on many shapes but all have the same important implication and contain two common elements. A horizontal line which represents the open and close (occurring at or near the same level) and 2) a vertical line representing the total trading range (high and low) during the time period represented on the chart.

Below is a chart of the US Dow Jones industrial index. As you can see, the industrial’s price is approaching the high levels made last November. What should also be clear is that a doji formed Monday. I ask you to let your eyes drift left and look at what happened each time a doji (circled in blue for your convenience) occurred in an extended uptrend. Do you see a pattern that repeats? If so, we all must be wondering if it is finally time to take a breather from this over-extended counter trend bounce off of last Christmas eve’s low prices and expect a pullback? Or will this uptrend be strong enough to overpower the return of the doji?

A Nice Rounded Bottom

After being crushed by more than 60% (peak to trough) over the past year, Chinese retail giant, JD.com. JD, looks worthy of your investment dollar consideration. Not being a fan of v-shaped bottoms, those that base sideways or (preferably) in a saucer-shaped, rounded bottom pattern, have the potential of being much longer-term winners and as such, are more desirable. As you can see in the one-year daily chart of JD below, that is exactly what has taken shape. It’s not just the shape of the set-up but also the volume confirmation (bottom pane) that is occurring. On the way down, the biggest volume bars were red telling us of institutional distribution (follow the money). Eventually, the red bars begin to get smaller and then replaced by big green ones, indicative of institutional accumulation (follow the money).  Protracted moves in either direction must be accompanied by institutional activity otherwise their longevity becomes suspect.  

In addition to price and volume, RSI momentum is above 50 and rising. While its 200-day moving average is still declining, it is flattening. Price is currently above its rising 50-day moving average all the hallmarks of what you need to see in an early trend reversal

A confirmed break of the green horizontal saucer neckline points to a target at T1 some 25% above. A resurgence in the Chinese economy (brought on by an end to the trade-war perhaps?) could push the stock back up to last year’s highs, offering the potential for a 90% winner. With investment capital recently flowing into emerging markets, including China, a continuation or worsening of US-China relations would likely turn this potentially big winner into something quite the opposite. Invest accordingly.   

Your Turn

Those long-term followers know I use ratio charts as a part of my process, mostly to help determine where best to allocate investment capital. As with investment prices, trends persist when it comes to outperformance (ratios). The chart below I call “Risk On” is a ratio of the US SP500 stock index performance to US 30-year treasury bonds and its message helps define current risk levels. If the ratio is rising, risk is low and you have achieved (and will likely continue due to trend persistence) the best return by investing in US stocks only. If the ratio is falling, risk is elevated and bonds are out-performing.

With a quick glance, what should be immediately noticeable is the ratio broke below its rising uptrend support line in November of last year. This occurred at the same time when RSI momentum (upper pane) diverged (both short term and longer term) with the ratio warning of an increase in risk and possible trend change. From that point the ratio was crushed with the strong year-end selloff in stocks.

With stocks rebounding strongly from their massively oversold condition the ratio has, as you would expect, mirrored its move higher. Uninspiringly, the ratio closed out yesterday still below its falling 200-day moving average and has yet to make its first higher low. Looking left we see that the ratio is about the same place it was 12 months ago telling us that stocks and bonds have had a comparative return. Now what?

Closing out this post right here intentionally not providing a summarization or point to the post, I am wondering how you would interpret the charts message? Pile in to stocks gunz a blazin’? Stay on the sidelines in the safety of bonds and let the dust settle? or something in between?  I’d love to hear your thoughts and opinions.

GOLD – The Possibilities

Viewing the barbarous relic from a very long-term can help filter out the day-to-day noise. As you can see in the 20-year chart below, Gold’s price (the middle pane) was in a strong uptrend that lasted nearly 13 years, ending in 2011. In the bottom pane, you can see in the ratio of performance between gold and the US stock market, gold massively outperformed, exceeding the SP500 by more than 600% at its peak during that uptrend period.

As you would expect, 2011 not only marked the end of Gold’s uptrend but also its out-performance as stocks have gone on to outperform gold by almost 500%. Investor should be thinking to themselves why be in stocks when gold is outperforming? and vice versa. Diversification?

Gold’s price bottomed at the end of 2015 and has risen slightly since then but has gone nowhere for almost 6 years. Do I need to even say it? It’s been “dead money”. What has caught my attention though, is the saucer bottom that gold’s price has taken on that has formed over that “dead money” period. I shouldn’t have to mention the potential inverse head and shoulders bottom reversal pattern that is in development and screaming out “NOTICE ME”. Please note the word potential as it still has a lot of work to do to get to where it is something more than just “in development”. I have been watching this build out over the course of years and it’s been an agonizing tease as it has failed to breakout above the horizontal resistance zone at least 8 times. As we approach that zone once again, will this time be any different? Or will we get our investment hands slapped once again?

The key for me to over allocate investment capital will be to see at least two things 1) Golds price break out above the pattern’s neckline (blue horizontal resistance area) sooner rather than later before the pattern becomes unsymmetrical and invalid; and 2) a higher high followed by a higher low made on the bottom performance ratio chart. Until then any position in gold is nothing more than a trading vehicle.  

At its current pace, investors will be lucky to see both of these items happen in the near term as such it stays on our radar and is stalked. Besides the potential for a future profitable investment opportunity, the other major take-away’s (something I continue to reinforce every chance I can) are 1) investment themes trend for years as such being able to recognize turning points is key to long term out performance 2) just because an investment opportunity can make you money, it may not be worth your investment capital if it doesn’t outperform your other ideas/holdings.