Long-term analysis of the Dow

Discussion in 'Trading' started by deronwagner, Nov 26, 2002.

  1. While doing extensive ETF research last week, I came across some interesting charts of DIAMONDS (DIA), the tracking stock for the Dow Jones Industrial Average. As short-term traders, we rarely study charts of long-term, multi-year duration because we focus on trading short-term moves consisting of hours or days. While our style is not to trade long-term moves in ETFs, it is very helpful to have an idea of what the "big picture" is with any given index or ETF. Even though we usually do not trade patterns we see on weekly or monthly charts, knowing the greater context of what is happening in the broad market helps us to have a better, more accurate perspective of how to approach our intraday and multi-day "swing" trades. Because I was intrigued by what I discovered while researching some longer time frames of DIA, I wanted to share my observations and analysis with you. I do not intend this article to be a bullish nor bearish portrayal of the Dow, but rather a purely technical observation and analysis of various timeframes.

    Let's begin with looking at some raw statistics about DIA (and correspondingly the Dow Jones Industrial Average) since the all-time highs that were set in September of 2000. DIA is presently down 22% off its all-time high, after being down as much as 36% off the highs in the middle of last month (October 2002). However, there have been many strong selloffs and subsequent bear-market rallies during the past two years. Since the highs of Sept. 2000, my research shows there have been a total of six rallies of more than 10% each in DIA (and the Dow). Here are the time periods and the approximate percentages of each of those rallies in DIA:

    Approx. % of rally Date range of rally
    13.6% Oct. to Nov. 2000
    24.8% March to May 2001
    29.5% Sept. 2001 to Jan. 2002
    11.1% Feb. 2002 to March 2002
    20.9% July 2002 to Aug. 2002
    23.6% Oct. 2002 to present

    Based purely on the historical rallies of the past two years, the current rally in DIA would likely be nearing an end based on the average and maximum rally percentage of each bounce in DIA.

    Next, we will look at the widely-followed daily chart of the Dow. Below is a one-year daily chart of DIA, which closely mirrors the Dow at an approximate price ratio of 1:100. Therefore, simply multiply the price of DIA times 100 to calculate an approximate price match of the Dow Jones Industrial Average:

    [​IMG]

    In the short-term, it looks quite possible that DIA will rally up to its next resistance point of 91, at which point we are confident the Dow will see a big retracement (if not sooner). The 91 level on DIA is a significant resistance point for several reasons. First of all, it matches the most recent price resistance on the daily chart, which was set on August 22 and 23 of this year. However, more significant than price resistance is the 200-day moving average, which is still descending and is currently just over 92. If DIA rallies to 91, it would probably take several weeks, thereby causing the 200-day moving average to descend lower, probably very close to 91. This correlates to the price resistance from those highs at the end of August.

    Another interesting thing I noticed was that 91 perfectly correlates to a 50% Fibonacci retracement from the highs of March 19, 2002 to July 24, 2002. The 50% retracement level typically serves as an important and difficult resistance level for indexes to rally through. When indexes that are in a downtrend rally through the 50% retracement level, it often signals a trend reversal corresponding to the timeframe you are applying.

    Finally, depending on how long it takes DIA to reach the 91 level (assuming it does in the first place), it will also run into resistance of the upper channel of the downtrend from the highs of March 19. If DIA rallies to 91 quickly, this trendline will be slightly higher than 91. However, if it takes DIA several months to reach 91, the trendline will simultaneously be around the 91 level. Either way, the point is that there are at least four different reasons why there is significant overhead resistance around the 91 level that would take some major buying pressure to break through, although it is certainly possible. If DIA has enough strength to get through its resistance at 91, a quick look at the weekly chart shows a longer-term, more important trendline that DIA would have to rally through. Take a look at the weekly chart of DIA:

    [​IMG]

    Again, the 200-period moving average is closely lined up with the upper channel resistance of the downtrend from the highs of May 2001. If DIA rallies that high, the 200-week moving average will probably be lined up precisely with the upper channel of the primary downtrend line. Therefore, if DIA breaks above 91, it will run into big resistance just over 100 (10,000 on the Dow).

    Finally, let's take a look at the monthly chart of the Dow, which presents a very sobering snapshot of reality. Since the DIA ETF is only a few years old, we used a chart of the Dow Jones Industrial Average instead to get a long-term monthly view of the past 20 years. I used a line chart instead of candlesticks because it is easier to see the trend over that long duration. Check out this chart that goes back exactly 20 years to the day:

    [​IMG]

    When I first looked at this 20-year chart, the first thing that grabbed my attention is how huge of a rally the Dow has had over the past 20 years. Despite the 22% selloff from the highs of September 2000, the Dow is still up a whopping 885% since 1982. After studying the huge gains of the past 20 years and looking at some trendlines and indicators, you can probably guess the next thing that went through my head. . .the Dow has a really good shot of dropping another 3000 points or more before finding solid price support of the primary uptrend line around 5200 and the 200-month moving average around 5500.

    Now, before you start to panic and bury all your cash in the back yard because you fear the Dow dropping to 5000, be aware of two things:

    1.) The Dow could easily take another 3 - 5 years before ever seeing the 5000 - 6000 price level. Remember that we are looking at a 20 year chart here. Unless you have a very long-term horizon, shorting the Dow and expecting to make 40% profits is not likely.

    2.) The Dow could also trade sideways at current prices for the next 10 years or so without ever dropping below its support at 7500. This would cause the 200-month moving average and primary trendline to rise up and provide support through a correction by time, rather than price.

    Even though the longer-term trends are not tradeable with our particular style of trading, I strongly believe that having an idea of what indexes look like on multiple time frames greatly improves your profitability in short-term trading because it gives you a healthy perspective of "the big picture." Also, remember that the longer time the time frame of a trend, the more significant that trend is. Therefore, support and resistance levels mean more on a weekly chart than a daily chart, they mean more on a monthly chart than a weekly chart, etc.

    If you ever entered a position that just did not go where you expected it to go, yet you did not see any resistance on the daily chart, chances are good that there was an important trendline or support/resistance level that you overlooked on a longer-term chart. My hope is that you will learn from my analysis of DIA as a sample of the types of research you should be doing on the major indexes each week because you just never know what surprises you will come across when studying the longer-term charts.