Is that the Sound of a Dead Cat Bouncing?

The markets are bouncing. Quick get on board before you miss the train. It’s all up from here.

A 250 point rally in a week from very oversold levels is enough to get anyone’s heart racing. Is this the low of the pullback? Is the uptrend from March 2009 still intact and therefore is this the time to jump back into the markets?

It could be. We have fallen 17% from mid-April to the lows in May which is a decent retracement. If the uptrend is still in play then you would expect the markets to find a base around here and start trending up again.

To gain a better insight into whether this current rally is an opportunity or a bull trap we will have to dig a bit deeper under the hood.

Volumes traded in the markets over the past week have been anaemic. For example yesterday’s volume of $3.7 Billion was in the top three lowest volume days this year apart from early January when everyone was on holidays.

Usually I would say that a rally on very poor volumes after a huge sell-off was more than likely a bull trap, but the difficulty with judging the current rally in this way is that we are in the middle of school holidays in Australia and post the end of the financial year a lot of Fund Managers will be off to Bali with the kiddies.

Our results season gets under way in August and the US reporting season is about to get into full swing. Most Fundies will sit on their hands during this period while they await the results to be released. Therefore it is to be expected that volumes will drop away in July and they have been doing so over the past few years only to see a bounce back in August.

Therefore the current very low volume that we are experiencing is a seasonal occurrence. It may not be possible to disregard this rally based on the low volume that is behind it, but it certainly makes me wary of jumping onto this rally at this point. When the music stops the market can be hundreds of points lower in a couple of days and all of the new buyers will be trapped.

To gain a better insight into whether this rally can continue it is perhaps better to have a quick look at the spread of data that is coming out at the moment.

Australian business conditions appear to be stabilising at quite healthy levels. After hitting a two year high of +13 three months ago the Business Conditions Index has stabilised at +8.

In the last two weeks we have seen the Central Banks of Malaysia, Taiwan, Korea and India all lift rates and after our strong employment numbers last week we are probably going to see rates raised here before long. Also the IMF came out last week to increase their projections for world growth in 2010.

This all points to the recovery actually gaining a firmer footing as time goes on and would make current prices look like a bargain.

Now what are the warning signs that we should be taking notice of?

Chinese steel demand has weakened off substantially in the last few months. Iron Ore spot prices have collapsed to their lowest level for the year having dropped by nearly 40% since mid-April.

This sharp slowdown in Steel demand may be a sign of weakening growth in China and could bleed through to weakness in our resource stocks going forward. The outlook over the next quarter will be weak and expectations may be set too high currently.

I think it is far more important to be listening to China’s heartbeat at the moment than anything else.

Also it is interesting to note that the correlation between stocks on the S+P 500 is at its highest level since the 1987 stock market crash as pointed out in The Wall Street Journal.

This is not a call for an imminent crash but it is food for thought.

Now let’s turn to the technical picture currently and ask ourselves whether now is a good time to buy.

This first chart shows the ASX 200 daily chart going back to 2002. In it I have drawn an ellipse around every time the 35 day moving average has crossed under the 200 day moving average thus sending a long term sell signal.

The first occurrence was in early 2002 just prior to a sharp sell-off that lasted until the beginning of the US/Iraq war in March 2003.

The next occurrence was in early 2008. We all know what happened after that.

The third occurrence was in early June 2010. I don’t know about you but that alone is enough for me to remain on the sidelines in the face of this current short term buy signal. Until the 35 day moving average is back above the 200 day moving average I have to say that the market is in long term downtrend.

If we have a closer look at the market what do we see?

This chart shows the number of times in the last few years that the 10 day moving average has crossed under the 35 day moving average. You can see here that when the 35 day is under the 200 day and thus in long term downtrend, a crossing of the 10 day moving average under the 35 day moving average has had a very high strike rate in terms of being a good intermediate downtrend sell signal. It is only while we were in long term uptrend that the signal had a lower strike rate.

Also when looking at the long term price action in this chart you can see that the rally from the lows in March last year reached the 50% Fibonacci retracement at 5000 points in the ASX 200. If we are still in a secular bear market as I believe we are, then a retest of the 50% can be the beginning of the next leg and could take us back to the lows reached in March last year.

We are in intermediate downtrend having just confirmed that we are now also in long term downtrend, but we have bounced 250 points in the last week.

When looking at it from this point of view, the 250 point bounce looks like a drop in the ocean and if anything is a clear bull trap. I will not be advising anyone to jump on this rally, but that doesn’t mean that I’m not wrong. It just means that the big picture is far too bearish for me to try and pick up pennies in front of bulldozers.

Murray Dawes
For Money Morning Australia