The Market May Be About To `Start Acting Ugly'

To the untutored observer, there is nothing terribly ominous about a chart of the Dow Jones industrial average. Up goes the line in January and February, when the Dow surged by 400 points, before making brave--if fruitless--forays at 3000. It hasn't gone much higher, but it's trying, no? Well, to professional chart-watchers--stock market technicians--the squiggles in the chart are fraught with danger.

From Gainesville, Ga., home of the widely followed Elliott Wave Theorist newsletter, to Wall Street, where Merrill Lynch & Co. technical analysts are espousing caution, technicians are widely predicting grim tidings for the market. They expect stocks to increase substantially during the summer, perhaps rising well above 3000 on the Dow, with a thudding decline thereafter. Indeed, some analysts are warning of a possible reprise of the events of 1987--when the market rose to record levels during the summer, only to crash in October. "Our work strongly suggests that the market is going to form a major top in the second half," says Dave Allman, director of research at Elliott Wave.

The technicians' skittishness flies in the face of generally upbeat conventional sentiment among institutional investors and brokerage analysts--and that's not too surprising. Unlike analysts, who examine market fundamentals such as earnings trends and future dividend flows, technicians examine statistics based on price and trading volume. The aim is to get a handle on the supply and demand for stocks, which determine the direction of prices.

When technicians aren't poring over statistics, they are eyeballing charts--and that's one area in which, some maintain, the market clearly displays weakness. The American Stock Exchange Composite Index, for example, is showing signs of a "double top"--often an indication that the market is about to reach a peak (chart). Likewise, the Dow's seesaw-like motion--its adherence to a narrow "trading range"--is also viewed by many technical analysts as a portent that the market is far from a picture of health.

OUT OF BREADTH. Many technicians are also expressing qualms about the market's lack of "breadth." Breadth indicators include various formulas that compare the number of stocks that advance to those that decline. The higher the breadth, the more stocks are participating in the advance of the stock market indexes. And indeed, a decline in breadth was one of the earliest technical indicators of the market's weakness in 1987. Once again, some technicians maintain, the market is riding for a fall. "This has been a very mixed market. The old saw about this being a market of stocks, and not a stock market, has never been more true," says Stan Weinstein, editor of The Professional Tape Reader newsletter.

To Weinstein, the most telling indicator of the market's weakness, despite its occasional rise above 3000, has been the failure of most stocks to join the Dow in rising to record levels. He notes that each time the market has broken above the 3000 number in recent months, it invariably failed to take very many stocks with it. When the Dow closed over 3000 on Apr. 17, 694 stocks joined the Dow in reaching new highs. But on the next foray over 3000, in May, only half that number reached new highs. More recently, on July 18, the number of stocks celebrating new highs was just 220.

If well-known technical indicators such as breadth gauges are sobering, so too are a host of lesser-known ones that are followed by market professionals. One trader and technician, Long Island-based Richard Diamond, notes that the indexes that are signaling caution include a "bellwether" index that combines IBM and General Motors share prices. He also uses formulas that work with volume data and analyse the number of new stock-price highs and lows. Says Diamond: "I don't really care about the formula, so long as it works."

'SELF-FULFILLING.' Long-term technical indicators are of crucial importance to futures and options traders, even if they don't hold positions for longer than a day or so. Traders watch for a confluence of both long- and short-term trends, as a way of predicting short-term market moves. Thus Diamond, who gives seminars on trend-based trading, is closely tracking long-term indicators even though he is a short-term trader. "The market has more to go before it reaches a top--maybe 3200 or 3300--but I don't know when that will be," says Diamond. "But at some point it is going to start breaking trend lines and acting ugly."

Technical analysts, however, did not predict the crash of 1987--even though some technicians, including Merrill Lynch's Robert Farrell, were sounding cautionary notes through the preceding summer. Now, Merrill technicians are predicting a rise in the Dow to perhaps 3100 before a decline of 8% to 12%.

Richard McCabe, manager of Merrill's market analysis department, concedes that this is hardly a unique sentiment. And that may be the most ominous aspect of the technicians' wariness. "If this really is a popular notion and money managers become concerned about it," McCabe points out, "it might become a self-fulfilling prophecy." And when money managers start stampeding for the exit door, the rest of us can only follow--or be trampled.

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