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Four Month Rule

THE GENERAL MOTORS INDICATOR IS AT THE JUNCTION OF TOPPING ROAD AND BEAR MARKET DRIVE

We are currently in a short position on General Motors, so this is an apropos time to review "the four-month rule."

The four-month rule was created by well-known technician Martin Pring in his book Technical Analysis Explained. It focuses specifically on General Motors and states that in a bull market GM must make a new high within four calendar months of its previous new high. If it doesn't, then the bull market is over or is in a topping pattern. In other words, the bull is reversing into a bear. The opposite is also true. In a bear market, if GM fails to make a lower low in four months, then the downtrend is about to reverse or has already done so. The indicator tends to work better at tops than bottoms where there is a lag effect.

Can a single stock be this predictive? One only need remember the famous saying that "What's good for General Motors is good for America" to at least give the idea serious consideration. In many ways, the company is a microcosm of the U.S. economy. Because cars are heavily financed, its sales are very sensitive to interest rate changes. Fluctuations in the price of oil can have an important effect on car and truck sales, particularly with the company being a key player in the SUV market. When consumers are less confident, they will defer big-ticket items such as cars, so the company typically does well when consumer confidence is strong and rising.

The General Motors indicator has predicted many previous market tops. What is it signaling now? The last time General Motors hit a new high was early-January 2004. It has been over six months since GM reached this high, so the stock is saying that the bull market is either over or is in the process of reversing. Regular readers of this newsletter know that I have been hypothesizing for some months that the stock market appears to be forming a stage III top, one which will lead to a stage IV bear market decline. General Motors is confirming this analysis.

Below is a chart of General Motors going back to October 2002 when the stock made its first important bear-market bottom at $29.95. The shares then rallied and reached a high of $40.36 in early December 2002. The $40 level is a key turning point for General Motors and one which is current major support. 

From there, General Motors came down to $29.34 in March 2003, forming a double bottom despite the marginally lower low. This double bottom was the beginning of what eventually evolved into an inverted head and shoulders formation.  Based on the measuring principle, this implied a minimum target of $51 for the stock. A rally took the stock to $37.05 in April and it then declined to a higher low. Finally in June 2003, GM reached its first higher high within a four-month period, but failed near $40 resistance, peaking at $39.50. This point is marked with a "1" on the chart.

GM then retreated to support at $35 and by August 2003, well within the four month time-frame, broke through to new high ground taking out $40 resistance. This is point "2." GM then backed off, held support at $40 and by early January 2004 (point "3") rallied to what has so far been its bull market peak of $55.55 

From there, GM's road has been downhill. The stock pulled back to support near $45 in March 2004 ("4"), attempted a rally in April, but failed well below the previous high at $50.04 ("5"). During this time GM went through its sideways (to slightly rising) 30-week moving average and began to enter into a stage III topping pattern. A renewed decline brought GM to its mid-May bottom at $42.88 ("6") and a failing rally lifted it to $48.27 (point "7"). Again the stock failed to make a new high in four months.

A close look at the GM chart shows that the 30-week moving average is curling ever-so-slightly down, perhaps warning of an imminent stage IV bear market decline. GM's mid-May low of $42.88 is the price at which the stock must put on the brakes to end this current skid. If not, then a test of important support between $40 and $41 is probable. I would expect the first test of important support to hold. Hence, I will be on the lookout for a countertrend swing trade from the long side if GM probes $40 and I will alert you when I see the opportunity. 

For now, GM is in a long-term downtrend established in January 2004. To break out of this downtrend, the stock would need to rally above $47 and to reverse the bearish pattern, taking out previous resistance at $48.27. A high above $55.55 seems almost out of the question and in any case would take more than four months to occur.

The four-month rule is one more indicator that says the overall market may be topping out. It is one more warning sign that the bull market, which began in March 2003, is waning and investors will likely soon meet face-to-face with the bear. Unless you're short, Topping Road and Bear Market Drive will likely be a tricky place to travel.

Good trading!



Dr. Melvin Pasternak
Editor
The StreetAuthority Swing Trader