- New Science in old markets -

Stocks after those bottom extensions, bonds falling toward support

The rally in stocks that started on Friday 17th after bottom extensions in the US and elsewhere has been very sharp. This is in line with our repeated warnings that greater equity market volatility would be the ‘new normal’ but the pace of it is characteristic of a move caused mostly by short-covering. This does not mean that this is a ‘false’ rally and we recommend holding on to long positions taken from our Friday 17th edition - many substantial stock market rallies start with short-covering.

Whatever the longer-term implications may be, we are still keeping our US equity advice short-term until the present compressed condition in the Dow transport index is resolved. That index stayed in its range throughout last week’s drop and this week’s rally, so we still wait to make any longer-term pronouncements. This price range has been going on since June but the index is highly compressed so a break is imminent.

In such a range it is sensible to take profits as they become available so we try to identify in advance any points that might provide an exit. Both US and German indices are rallying toward recent daily-scale compressions that will offer the first resistance to this rally:

We will advise if we think any action should be taken if and when these compressions are reached but nervous traders might just take some profits there and wait. For those with stronger stomachs we would advise staying long as the bottom extensions are still quite fresh.

Interestingly, bonds have fallen as stocks have risen. This is entirely to be expected as the two have a strong inverse correlation lately but it brings bonds back towards support. There were daily and weekly-scale compressions just before bond futures ran up to last week’s highs and those will now provide support. The first chart is of price, showing the daily-scale compressions – support starts just above 149. The second chart is of yield (so is the inverse of price) and shows that longer-term price support will start when yields get up to reach 2.85% from the present 2.81%.

This weekly-scale compression (and others like it in price charts) has already broken in the direction of higher prices and we argued in the September 28th edition that this probably meant much bond higher prices to come. Dips back down to support levels like this are an opportunity to buy for the months ahead. It may also prove to be the case that this will have a positive effect on stocks so ending the current negative relationship between the two assets.

Elsewhere, compressions continue in some European equity indices - Spain, Italy, France and Belgium. These have all made a number of prior compressions too so this gives no useful clue as to what they will do next. Regular readers will know that we favour selling the Southern Europeans whenever it is time to put on any shorts in Europe, so we wait for some clarity before recommending further action in any of them.