What is happening in the Market, What are we doing about it? Part 1 of 3

Are we at an inflection point in the market?
I went back and looked at volatility and created the following analysis.
I tracked the number of days that the Dow high and low moved <100 points, 100-200 points, and >200 points.
Days >200 >100 <100 % TTL Days >200
Feb-06 1 7 0 13%
Jan-06 4 14 2 20%
Dec-05 2 18 1 10%
Nov-05 1 18 2 5%
Oct-05 7 14 0 33%
Sep-05 0 20 1 0%
Aug-05 0 22 1 0%
Jul-05 1 19 0 5%
Jun-05 2 20 0 9%
May-05 2 18 1 10%
Apr-05 11 10 0 52%
Mar-05 2 19 1 9%
Feb-05 1 18 0 5%
Jan-05 2 18 0 10%
Dec-04 1 19 2 5%
Nov-04 2 18 1 10%
Oct-04 4 17 0 19%
Sep-04 0 20 1 0%
Aug-04 1 20 1 5%
Jul-04 4 17 0 19%
Jun-04 0 21 0 0%
May-04 5 15 0 25%
Apr-04 6 15 0 29%
Mar-04 3 20 0 13%
Feb-04 6 13 0 32%
Jan-04 6 14 0 30%

This is I am tracking daily volatility by looking at the difference between the daily high and lows of the Dow. Then I am counting the number of days that the volatility exceeded 200 points. I then look at the ratio of 200+ point days as a share of total trading days.

The period Jan04~May 04 was a period of high volatility. This was also a major inflection point – the Dow had zipped up almost 3000 points.

The volatility neatly tracks large downward turning points in the market.
Jan~May 04 – Market tanked 800 points
July 04 – Market tanked 700 points
Oct 04 – Market tanked 500 points
Apr 05 – Market tanked 800 points
Oct 05 – Market tanked 400 points
Jan/Feb 06 – Market hasn’t moved but has bounced around 300 points 3 times

I also tracked the number of times the Dow closed up or down >100 points.
This happened >20% of the trading days
Jan-May 04 - lots of 30%+ months
Aug & Oct 04
Apr-May 05
Oct 05
Feb 06 (insufficient data to use as a trend)

What are my takeaways:
1. For the past 2 years, volatility is always downward
2. Dow climbs back gradually and steadily afterwards
3. Large intraday fluctuations translate into declines
4. The recent volatility (Jan/Feb 06) has been a combination of sharp and sharp down movements within one month, whereas most upside movement in the past has been more gradual

2004 was typified by a series of 3 month cycles swinging 6% up and down and 2005 was typified by two 6 month cycles ~7% up and down. These track quarterly results quite nicely. It is possible that 2006 will continue this 6 month cycle where we ease back down to 10300 by May and then move again.
But I think we will actually continue to go up or stay flat because 2004 and 2005 were very much influenced by oil shocks. Oil is not going to be as volatile.

http://finance.yahoo.com/q/bc?s=%5EDJUSEN&t=5y&l=on&z=m&q=l&c=%5EDJI
I can't paste a chart, so this is a link to the Dow Jones versus the Dow Jones energy Index.
2001-2002 are pretty much the recession period and beginning of the rebound. At this time, the Dow and the Energy move fairly the same.
2003 is the year of return – the Business cycle is firmly kicking in and both indices are returning to pre-recession levels.
And then things change. Energy surges and the Dow goes nowhere.

http://finance.yahoo.com/q/bc?s=%5EDJUSEN&t=1y&l=on&z=m&q=l&c=%5EDJI
The same chart but at a 2 year snapshot
Energy rose 10% in June 04, and the market tanked July 04
Energy rose a further 15% in Sept 04, and the market tanked Oct 04
Energy was flat until Jan 05, the Dow rose 1000 points
Energy surged 25% Jan-Feb 05 and stays there, Market tanks April 05
Energy surges 40% May – Sept 05, no change in the Market until Oct 05 when the market tanks
Energy softens and drifts Oct – Jan, Market rises

It would appear that the market lags rises in energy prices. As if investors don’t think energy prices will affect profits, and then they realize that the opposite may be true.

I am saying that the Dow has been prevented from rising because of oil prices. If oil goes up, expect the Dow to remain constrained. If oil begins to soften, the Dow will go up. I believe that oil will begin to soften unless Iranian tensions flare up and oil remains high for an extended period of time.

My basis for believing this is that the US Business Cycle is entering the phase of overcapacity and slowing demand. Much of that demand will be replaced by India and China for internal use. But much of China’s demand for commodity is actually to meet worldwide demand for finished goods. If that demand slows, so will Chinese demand for raw materials.

A softening of commodity prices is happening in steel already de to overcapacity.

In general, a softening in the cost of raw materials will boost margins and keep the economy humming along.

So I am concluding
1. Volatility has been a guaranteed negative sign for 2 years (and maybe more)
2. The Jan/Feb 06 volatility seems to be an exception. Volatility without downward movement is a sign to me of an upward inflection point. That the market is testing the downside and snapping back sharply.
3. A lot of volatility and the overall inability of the Dow to move has been partly a factor of oil prices
4. Easing or flattening oil prices will enable Dow upside
5. The quarterly cycling of 2004 became 6 month cycles in 2005 as the market tried to move on longer term trends but oil kept pushing it back down. I'd like to thinkn that we could see a beautiful 6 month cycle.