The Implications of Dow 20K

Despite the media bringing attention to the stock market lately with the Dow Jones Industrial Average (INDU) making an all-time high by closing over 20,000 it is nothing more than a transitory news item in the scheme of a trading strategy. Instead of focusing on the INDU eclipsing 20,000 think of it as just another number like a memorable birthday. It is more important to focus on the market structure leading up to and currently surrounding these new all-time highs.

Structurally, the start of 2017 looks far different than 2016. Last year, trend indicators were implying that prices would be heading lower rather than finding a bottom in the months to come. For example, the slope of the 50, 100, and 200-day simple moving averages were all trending flat to down with shorter time frame moving averages leading to the downside. MACD exhibited a bearish crossover and MACD-H displayed a bearish turn lower. Additionally, price failed to make a new high during the latter months of 2015 which further emphasized a bearish market tone.

Conversely, the trend indicators during the start of 2017 display a more bullish sentiment. For instance, the 50, 100, and 200-day simple moving averages are all sloping upwards. MACD and MACD-H experienced a slight bullish crossover recently. Moreover, the long-term perspective on multiple timeframes displays a series of higher highs and higher lows; that is, an uptrend.

However, while the long-term perspective remains constructive for being long stocks negative divergence between the Relative Strength Index (RSI) and INDU has been developing since the middle of December 2016. Negative divergence between an indicator and price occurs when price makes a new high but the indicator makes a lower high. RSI is an oscillating indicating. That is, its value is range bound between 0 and 100. As such, RSI can help traders to assess the level of underlying market strength that accompanies a particular price high or low by comparing it against the level of the indicator.

As with all market analysis, divergences do not always have 100% accuracy. However, it is prudent to consider the lack of internal strength based on RSI in the context of the speed and distance traveled during the post-election uptrend.

Specifically, traders looking to make a tactical hedge to their strategic equity positions could buy call options on the Dow VIX (VXD) as this index recently hit long term lows. A volatility index acts as a sentiment gauge and low levels in the VXD represent investor complacency. VXD moves inversely to INDU as its value is derived based on the price of its options. In other words, at the moment there is not much demand for protection and volatility is under-priced. However, volatility by its very nature is mean reverting and should expand at some point. When that happens, being long a volatility hedge will buffer some of the decline in a core stock portfolio. 

Until the trend implies otherwise maintaining a strategic long position is permitted as price and long-term trend indicators still implore investors to be invested in equities. However, putting on a tactical hedge (e.g. selling far out of the money VXD call options to fund the purchase of VXD call options closer to being in the money) should provide a smoother return stream for investors by minimizing any drawdown from a correction that may occur in the near-term.

As always, please feel free to contact me with any comments or questions. Thanks for reading.

John