Trading the Dow 30 Bust

By: Adam Hamilton | Fri, Feb 21, 2003
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The venerable Dow Jones Industrial Average is probably the most important and most well-known stock index in world history. It is not only relentlessly watched within America, but also in practically every other first-world corner of the globe. It never ceases to be fascinating when traveling overseas to realize how many investors from other countries know exactly where the DJIA closes each day.

Many of the 30 enormous American companies that comprise the Dow Jones Industrial Average, in addition to creating its short name of "Dow 30", are also world leaders in their respective industries. If you go through a list of these companies, which includes General Electric, IBM, Intel, Coca Cola, Microsoft, and Wal-Mart, their collective pedigree, prestige, and power is simply breathtaking.

Interestingly, during the NASDAQ bubble days the proud Dow 30 seemed to take a back seat to the other major US indices. As the insatiable lust for tech stocks raged like a wildfire, both casual tech-bubble participants and active speculators alike gravitated towards the hyper-volatile NASDAQ and NASDAQ 100 as their indices of choice. The festering NASDAQ bubble exploded into the very nexus of speculative excess.

Professional money managers also shifted away from paying homage to the Dow 30 and instead gravitated towards the S&P 500. Professionals in the business of running Other People's Money, like mutual-fund managers, live and die by the S&P 500 performance benchmarks each quarter and year. The S&P 500 is the best major proxy for the US stock markets as a whole so money managers all compared their funds' performance to it.

These bubble crosscurrents conspired to create the odd situation in recent years where the Dow 30 slid in both popularity and prominence in most investors' minds. To this day, even as the Great Bear's vicious work in mauling away bubble excesses is now readily apparent to everyone, the NASDAQ and S&P 500 still attract much of the market limelight each day.

I too am definitely guilty of this bubble shift away from the Dow 30, as the number of my NASDAQ essays has exceeded my Dow 30 essays by a margin of greater than 5 to 1 in the last several years. As an active speculator I certainly find the hyper-volatility of the NASDAQ and its derivatives like the QQQs extremely alluring, but truly in the grand long-term scheme of things the Dow 30 is really far more important.

As any student of the markets will agree, the Dow 30, NASDAQ, and S&P 500 are intimately related and seldom make big moves up or down unless all three indices are along for the ride. The links between these three flagship indices extend far beyond superficial similarities in daily behavior though.

Amazingly, all 30 elite companies anchoring the Dow 30 are also members of the S&P 500 and together comprise a whopping 32% of the entire market capitalization of the 500-member S&P 500 benchmark index! With a third of the S&P 500's value directly dependent on the Dow 30, as goes the Dow so goes the S&P 500. Talk about influence!

The two most important NASDAQ companies, the fantastically successful duo of Microsoft and Intel, are also valuable members of the elite Dow 30 club. Interestingly these two American success stories alone command a phenomenal 31% of the entire market capitalization of the 100-member NASDAQ 100 index!

Thus in all-important market-capitalization terms the Dow 30 companies account for about a third of the S&P 500 and a third of the NASDAQ 100! So regardless of how you speculate in the US equity markets, no matter which particular speculation vehicles you prefer to traffic in, it is crucial to pay attention to the mega-influential Dow 30.

As the Dow 30's perpetual machinations can make or break index speculations in both the S&P 500 and NASDAQ arenas, all speculators must keep one eye on the Dow as well. In this spirit this week I would like to discuss the prospects for actively trading the Dow 30 itself for active speculators playing the ongoing Great Bear bust. The NASDAQ sure ain't the only game in town!

As always, it is crucial to begin with a grand big-picture strategic perspective. Only by digesting the Dow 30's price behavior over more than a decade can an investor or speculator truly understand where the Dow is most likely heading in the coming years.

In these Dow 30 graphs this week we also included the VIX S&P 100 Implied Volatility Index, today's premier general stock-market sentiment indicator. While the VIX is priceless for the art of S&P 500 and NASDAQ/QQQ index speculation, it is even more relevant to the Dow 30 itself.

The Dow 30 utterly dominates the S&P 100 index from which the complex VIX implied volatility calculations are derived. 29 of the Dow 30 companies are included in the S&P 100. These 29 companies, believe it or not, account for a colossal 56% of the total market capitalization of the entire S&P 100 index! The popular VIX is far more closely-tied to the Dow 30 than it is to even the S&P 500, let alone the NASDAQ. The VIX is hugely important for Dow 30 index trading.

Briefly digressing on a market trivia side note, in case you were wondering the single Dow 30 component that didn't make the grade for the S&P 100 is Caterpillar.

For all you fellow heavy-equipment fans, this is indeed a sad state of affairs. Next time you are blessed with a big index speculation win, consider going out and buying yourself a shiny new Caterpillar bulldozer. These monster machines can eat Hummers for breakfast! Then you will not only never have to sit in a traffic jam again (you can plow right through), but you can have hours of good clean fun terrorizing your neighbors. In addition, you can rest happy in the fact that your purchase is helping a great American company move towards S&P 100 inclusion.

And now on to our Dow 30 strategic overview…

The crucial wisdom to glean from this long-term Dow 30 chart is that it too participated in the late 1990s US equity mania. The Dow 30 bubble was nowhere near as extreme and aggressive as the mighty NASDAQ bubble, but it was still a bubble nevertheless. Bubbles have consequences, and this ongoing Dow 30 bubble bust will ultimately be as brutal and unforgiving as all other major bubble busts in history.

The Dow 30 bubble started festering in the mid-1990s, when the index leapt out of its long-time normally-sloped uptrend channel and started reaching for the heavens. Its steep bubble ascent was remarkably smooth and consistent with the notable exception of the very frightening August-October 1998 international financial crises. It achieved its all-time high of 11723 on January 14th, 2000, a couple months before the NASDAQ bubble topped. And since then we have been reaping the initial bitter fruits of the subsequent Dow 30 bust.

All Dow 30 investing and speculating decisions in the next couple years should be made in light of the extremely high probability of the primary Dow 30 bear continuing until the bubble excesses are completely purged from the index. Every few months Wall Street brazenly claims that the Dow has finally bottomed, but they are just selling blind optimism as usual. The ultimate Dow 30 bottom won't be laid in until the index is way undervalued, which is discussed further below. Don't forget the big strategic picture shown above as you trade the Dow 30 index!

In order to be mauled back down to undervalued levels by the ongoing Great Bear, the Dow 30 is going to have to plunge well below its long-term uptrend channel drawn in yellow above. Like a great sine wave, since the index soared in a bubblicious mania for many years, it will also probably plunge far under its long-term uptrend in future years to bring its long-term average valuations back on track.

Like the classic feast and famine cycles, when a major index gets way overvalued it then faces a dismal near-term future of serious undervaluation in order to bleed off its earlier gross speculative excesses. The doodle in the lower-right corner of the graph above shows the most likely near-future path of the Dow 30. It will almost certainly trade down to undervalued bust lows that few can imagine today.

Speculators should take careful note of the long-term interaction between the Dow 30 and the VIX shown above in red. Every major interim Dow 30 low in the last six years or so, highlighted with yellow arrowheads above, has been precisely marked by its own VIX spike. Some of the VIX spikes ran up to the 50 range when great general fear abounded, and others merely approached 40 if investors were less nervous at the time.

Just like while trading the NASDAQ or S&P 500 indices, carefully monitoring the venerable VIX implied-volatility sentiment proxy is extraordinarily important for Dow 30 index speculators. The VIX is the speculator's best friend in sending out unmistakable warning signals when temporary fear is too great and an oversold V-bounce is imminent. Ignore the VIX at your own great peril.

Since we are sojourning through the grisly bubble aftermath today, the most important technical area of the graph is the bust data since 2000. We zoomed in to examine this accelerating Dow 30 bust in more detail below.

Of great interest to speculators is the viciously steep downtrend channel the Dow 30 has formed since mid-2000 or so. While the top resistance line of this downtrend pipe shown above is not well-defined, the bottom support line is extremely strong. The Dow 30 has seen major V-bounces off this bottom support line 4 times since its bust began and a fifth only temporarily pierced it before soaring back into the channel.

Point 6 above, where the Dow 30 temporarily fell out of the bottom of its downtrend, is probably not technically significant since it happened right after the 9/11 attacks when abnormally great general fear abounded. Those earth-shattering events introduced some enormous shocks into the US financial markets that took many months to shake out. Interestingly, the bear-market rally after the post-9/11 lows was the largest in the Dow 30 bust to date as the major disturbance and discontinuity worked itself through the markets.

Speculators need to take careful note of the VIX's behavior above relative to the Dow 30 itself. In each of the last three major downlegs, which all presented hugely profitable short-oriented trading opportunities, high VIX spikes marked the ultimate termination of each individual downleg. If you are short or putting the Dow 30, and a major VIX spike erupts concurrently with a wickedly sharp accelerating Dow 30 downleg, the time to cover your shorts and sell your puts for immense profits has arrived.

Interestingly, this covering of shorts on major VIX spikes idea is identical to the proven strategy for trading the NASDAQ/QQQs or S&P 500.  Since the Big Three US equity indices are heavily interbred kissing cousins as discussed above, major interim lows on V-bounces marked by VIX extremes virtually always happen on the same day for all three indices at once.

This level of index interrelationship is certainly a blessing for speculators though, because if you can trade one of the Big Three US indices successfully based on watching sentiment indicators like the VIX, then odds are you can trade them all quite successfully without a great deal of marginal effort. It is fascinating and exciting for a speculator to be able to apply his or her hard-earned trading skills to other arenas!

The Dow 30 bust to date can also be used to calculate simple average downleg and average bear-market rally targets as we did last week for the NASDAQ and QQQs in "Trading the VXN Wedge". These targets are not going to be right on the money, but they are useful for speculators to gain a general idea of about where the next bear-rally-apex interim top or V-bounce interim bottom might materialize in the Dow 30.

In terms of bear rallies, the last 3 major bear rallies in the Dow 30 have seen an average gain of 24% over 66 days. While the 24% seems reasonable for a typical bust bear rally, the average duration is skewed greatly by the post 9/11 rally (points 6 to 7 on the graph) which was not normal as investors and speculators were coping with a fundamental world change of immense magnitude.

If this large post-shock oscillation period is dropped, the average bear-rally duration runs 38 trading days, which seems much more appropriate. Our research published in "Bear Market Rallies 2" indicated that post-bubble bear rallies in history had an average duration of about 6-8 weeks as well. It is always encouraging when multiple independent lines of research lead to similar conclusions.

Dow 30 bear-rally averages are helpful, but since we are currently suffering through another downleg it is the average magnitude and duration of these beasts which captures our interest today.

The last 3 major Dow 30 downlegs shown on the graph above averaged a hefty 25% loss from their respective most recent interim bear-rally tops. Provocatively, every subsequent downleg we have witnessed thus far in the Dow 30 bust has grown larger than all its predecessors. For some reason they have been waxing more brutal each time, possibly because general investor recognition and fear of the Great Bear bust is multiplying. The average duration of these downlegs was 120 trading days, about six months from top to V-bounce bottom.

If we apply these simple average downleg stats to our latest Dow 30 interim bear-rally top of 8932 on November 27th, we can gain a rough idea of the potential havoc that could be wreaked in this current Dow 30 downleg.

Another merely average 25% downleg this time around would bludgeon the venerable blue-chip Dow 30 down to the 6700 level before the next V-bounce, quite a bit lower from today's 8000ish levels. An average 120-day duration would place the Dow 30 V-bounce in May or sooner. As outlined last week in "Trading the VXN Wedge" however, I suspect that the US markets will end up plunging on great fear into another V-bounce before the end of April.

When this eagerly anticipated V-bounce arrives, it will be time for speculators to cover all their active index shorts, sell all their open index puts, and prepare to throw long for the expected 6-8 week major bear-market rally that will erupt out of the short-term sentiment ashes.

Just as in the S&P 500 and NASDAQ, this ongoing Great Bear bust in the Dow 30 is likely to continue until the index reaches historically undervalued levels in valuation terms. Speculators should have at least several more greed-fear cycles left to trade, of bear-market rallies followed by ugly downlegs oscillating down through the primary Dow 30 downtrend channel shaded in blue on the graph.

If history continues to be a valid guide as it has all throughout our bust to date, the fabled ultimate Dow 30 bottom yet remains a long way down from here. Our final graph offers some insights into why the Dow 30 has a lot farther left to fall and why speculators can probably enjoy the old bear rally/downleg speculation game for several more cycles into 2003 and 2004.

This complex Dow 30 Valuation Wave Mean Reversion graph is explained extensively in "Valuation Wave Reversion" if you'd like some more background information. It shows Dow 30 valuation on the left axis, including the index's all-important price-to-earnings ratio in red and its dividend yield in yellow. The right axis maps the Dow 30 itself, with actual closing data in blue and a hypothetical Dow 30 at fair value (14x earnings) in white.

Just like every other major stock-market bust in history, the probability approaches certainty that this one today won't end until the Dow 30 is historically fundamentally undervalued. In the last 70 years of US history, the average long-term stock-market bottom occurred at a P/E of 7.6x earnings and a dividend yield of 8.3%. Major bottoms simply never happen above 10x earnings in history!

As of the end of January the Dow 30 was trading at 21.7x earnings and only yielding 2.1% (we compute these numbers real-time once a month to publish for our Zeal Intelligence newsletter subscribers). Dow 30 speculators can rest assured that the Dow 30 will be nowhere near bottoming until its P/E heads under 10x and its dividend yield soars above 6%. Until that fateful day, vast profits can be reaped betting on the massive ongoing Dow 30 downlegs and subsequent sharp yet fleeting bear-market rallies.

As far as actively trading the Dow 30 bust, speculators can play and leverage this exciting game with futures, futures options, or stock options.

Futures traders can go long Dow Jones Industrial Average Index Futures and/or buy index calls on these contracts at V-bounce interim bottoms, marked by extreme VIX readings. Then when the resulting reaction bear rally matures, which can be measured by the 21-day moving average of the Put/Call Ratio, futures traders can close all their long positions for big profits and throw short. Dow 30 index futures can be sold and index puts purchased to ride the coming downleg.

Stock-options traders can play the same game with the increasingly popular Dow 30 tracking stock, the Diamonds Trust. This Dow tracking stock is to the Dow 30 what the QQQs are to the NASDAQ 100, and trades under the symbol DIA. Extensive DIA options are available and are easily tradable in any standard options-enabled stock account.

When a V-bounce bottom arrives on an extremely high VIX reading, DIA traders should buy DIA calls positions expiring at least three months in the future. After the usual bear-rally reaction occurs, at the next interim top marked by extreme greed signaled by very low PCR 21dma activity, these DIA calls can be sold for big profits.

At the same interim top, extensive DIA puts positions can be deployed in anticipation of the coming downleg. These puts should have expirations at least six months into the future on deployment. Once the next V-bounce interim low arrives, the DIA options traders can sell their DIA puts for enormous profits and the whole cycle begins anew, at least until the Dow 30 reaches historically undervalued levels in fundamental terms.

We actively trade DIA options on the Dow 30 for our dear subscribers to our Zeal Intelligence newsletter if you are interested in learning more. While it is probably too late to join us in our already-deployed DIA puts for this current Dow 30 downleg, the subsequent bear-market rally will probably be awesome and we expect to be deploying those DIA calls when appropriate before summer.

The great game of speculation never ends, with glorious new opportunities approaching every few months or so. Trading a Great Bear bust can be immensely rewarding on multiple levels. Have fun!

I wish you Godspeed and great success in trading the ongoing Dow 30 bust!


 

Adam Hamilton

Author: Adam Hamilton

Adam Hamilton, CPA
Zeal LLC.com

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Mr. Hamilton, a private investor and contrarian analyst, publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis of markets, geopolitics, economics, finance, and investing delivered from an explicitly pro-free market and laissez faire perspective. Please visit www.ZealLLC.com for more information, www.zealllc.com/samples.htm for a free sample, and www.zealllc.com/subscribe.htm to subscribe.

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