Bad news is bad for the market, except when it is not. And, how do you know this? The old market wisdom is that if in the face of bad news market advances then its health is better than it looks and if it is in a uptrend then it will continue and if it is not in a uptrend then one would start soon. This is what happened during the week of May 23, 2016.

On May 18, 2016, Fed released the minutes of its April meeting. The minutes confirmed that strong consensus exist within Fed for a rate-hike in near future. Initial reaction by the market was swoon to the downside only to revert back up by the end of the week. Friday, May 20, many indices formed one-day reversal candlestick patterns.

The following week’s action hints that the short-term bounce may last a bit longer. During the week, the market rallied on most days and was pausing during other days. On Friday, Fed Chair Yellen opined that the rate hike is coming. The outcome was that S&P 500 and Dow Jones Industrial Averages had their best week since March. The gains for the week of May 23rd was the third largest for the year 2016. Only logical thing to conclude from this is that the market is stronger than many people think it is, notwithstanding sell-in-May-and-go-away doctrine.

With that in mind, let’s review the week gone by and read the tea leaves for coming weeks.

Market At The Upper Limit Of  Trading Range

We noted earlier that the S&P 500 has been on a uptrend since February 2016 and is breaking out of a down-sloping bullish flag. On weekly time-frame it is in a rectangular trading range, the lower bound of which the index entered in the summer of 2014. The upper bound of the rectangle is formed by the high of 2015. It has not yet broken the uptrend line from March 2009. The index is also making higher-highs and higher-lows, a good sign of a uptrend. Technically, the index briefly violated this rule when it dipped below August 2015 lows in 2016, but, since it did not close – on weekly basis – below the support level, we can ignore the breach and consider the uptrend intact.

S&P 500 is again knocking on the upper bound of the rectangle and, as the recent action demonstrated, showing strength. On 14-period RSI, it has broken out of a symmetrical triangle to the upside, suggesting increasing momentum. Many times break of trend on RSI is succeeded by the break of the trend line in the price. It remains to be seen if the price will do so but an inference that could be drawn is that the odds are good that the index would break the resistance. Off course it would need favorable responses from the policy makers, geopolitics and other players. As Yogi Berra said, “it ain’t over till it’s over“.

Dow Theory Is Not Very Clear, But Not Pessimistic

Dow Theory, first coined by S.A. Nelson in his 1903 book, ABC Of Stock Speculation, and based on the ideas of Charles Dow, the founder of Wall Street Journal, provides a good framework for market analysis. It was expounded by Robert Rhea. It uses two indices – Dow Jones Industrial Average and Dow Jones Transportation Average – to establish the trend of the market.

In its basic form, the theory says that during a uptrend, each successive rally closes higher than the previous rally high and each successive rally low also closes higher than previous low.In other words, in a uptrend, market forms higher highs and higher lows. The opposite – successive lower peaks and lower lows – define the downtrend. Dow Theory uses closing price.

Dow Theory also states that the two averages, Industrial and Transportation, must give the same signal for important bull or bear signal happens. When the two averages diverge then Dow Theory assumes that the prior trend is still maintained.  This is why it is important to distinguish between a normal correction and the start of a new trend as the price action of the two indices shows at present.

In August 2015, Dow Jones Industrial Averages closed below the previous swing low made in October 2014 for a short time. Transportation followed suit couple of months later in the year. Then the Industrial bounced back by much but Transportation did not. Industrial again closed below the low of August 2015 in 2016 only to back up above the intermediate high between the two lows. Transportation too declined below the low and then bounced up, but its bounce is not as significant so far.

So technically the two indices have closed below their swing lows but they are also diverging as Industrials are close to making new highs and Transports are also breaking out. One way to read this is that the uptrend is undergoing a correction and the downtrend had not occurred.

NASDAQ and Russell 2000

Smaller cap and more volatile, NASDAQ Composite and Russell 2000 are forming down-sloping bullish flags on weekly charts. Russell’s flag has a better shape, which the index seems to have broken to the upside. NASDAQ’s flag is broader and less slanted.

U.S. Still The Cleanest Dirty Shirt.

S&P 500 is again outperforming emerging and developed markets.

Emerging markets ETF, EEM, was outperforming SPY from February till April 2016. The ratio of EEM-to-SPY broke the uptrend line at the beginning of May. It remains to be seen if the uptrend is resumed or it reverses into a downtrend.

The SPY has been outperforming the developed markets ETF, VEA, for sometime. Mid-April, the VEA-to-SPY ratio broke downtrend line to the upside. The trend hasn’t yet turned up but it seems that the developed markets are performing better.

VEA-to-EEM ratio  is showing a uptrend since 2016 lows indicating that developed markets are outperforming emerging markets.

U.S. Economy Humming Along

One reason that the market is discounting the imminent Fed-funds rate hike is that U.S. economy continues to give out good news.

The Q1 GDP was revised higher to 0.8% instead of 0.5%. The jobless claims continue to decline. Industrial production jumped most in eighteen months by 5.8%. The data from housing front is also goo. Pending home sales increased 5.1% and the new home sales had the best showing since 2008 with inventory down to 4.7 months.

Next Week

Many important economic reports are due out next week that would impact the market.

• Core PCE Price Index and Personal Spending is due on Tuesday
• Conference Board Consumer Confidence is also due on Tuesday so is Chicago PMI
• Wednesday is ISM Manufacturing PMI day
• Thursday is ADP Non-Farm Employment day
• The big kahuna – Non-Farm Payroll report will be out on Friday along with Average Hourly Earnings and Unemployment rate

What these reports will show and how the market reacts to them regarding its interpretation of what Fed will do will be an important factor for its performance. For now, it seems to be intent upon going higher. So the default trade should be to the long  side unless next week’s economic reports throw very unpleasant surprise.