Dow Theory Redux

By: Henry To | Mon, Jun 27, 2005
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Dear Subscribers and Readers,

We switched from a 50% long position to a completely neutral position in our DJIA Timing System on the morning of June 13th at DJIA 10,485. Over the next three to five months, I still don't believe the probability favors the bull's side - there's just too much bullish sentiment given the overbought condition in the markets, the slowing global economy, and high oil and copper prices. The action of the final two trading days of last week confirmed our suspicions. The only consolation has been that the Philadelphia Bank Index is continuing to hold up relatively well. We had also previously discussed the possibility of switching form our currently neutral to a 50% short position, but we will most probably hold off for now - as the market has gotten away from us on the downside. As a rule, we have never really liked to trade on the short side very much - since we have always believed that the big money is usually made on the long side.

Hats off to Bill R. for providing such a great guest commentary last Thursday morning! For readers who wish to contact Bill, you can do so at the following address: nodoodahs@aol.com. Again, I encourage users to give positive/constructive feedback as much as possible, as the main purpose of our website is to use it as a forum to learn from each other (and hopefully make a profit or preserve your capital in the process)!

The economic situation in Western Europe has gotten more acute has I am writing this. Make no mistake - a healthy Western Europe is in the interest of everyone here in the North America and in the rest of the world. So far, Germany seems to be the major country that is best-prepared for reforms - while the French population is still very much holding on to their sense of entitlement when it comes to social benefits. Also, what is the likelihood of Italy breaking away from the European Union? For a quick scoop on the issues facing Western Europe, please read Mr. John Mauldin's latest take on the subject entitled: "The Idea of Europe." Like I have mentioned before, I would not be surprised if we see parity again between the US$ and the Euro during the next two to three years.

I want to begin this commentary by discussing the Dow Theory. For subscribers that are new to our website, please do take some time out to read about the history of the Dow Theory - as I believe it is a very powerful tool that can be used to navigate any treacherous markets - especially in this day and age when there is so much noise and conflicting information available about the financial markets. That being said, not many financial analysts or investors subscribe to the views of the Dow Theory - partly because of the "failure" of the Dow Theorists to promote this in any substantial way (it is difficult to get any credibility when even the Dow Theorists disagree among themselves on how to properly apply the Dow Theory) and partly because the Dow Theory is really "pushing it" because of the way the Theory makes so many assumptions on how the market should act based on historical precedents.

So what am I saying? Ever since Charles Dow originated the Dow Theory (although interestingly he never bothered to promote the Theory in any way), the concept of valuations and the primary trend have worked well for the practitioners of the Dow Theory. The latter is a very important assumption - as it implies that there is a valuation cycle when it comes to the stock market - similar to the existence of a business cycle in the capitalist countries of the world that still exists today despite the many efforts of the Federal Reserve, the European Central bank, the Bank of England, and the Bank of Japan to tame the business cycle. The valuation cycle assumes that a secular bear market always follows a secular bull market, and vice-versa. Many credible investment analysts dispute this claim - arguing that the movement of stock prices over the long run is too random to predict and that the Dow Theory is too rigid to be used in any meaningful way to analyze the stock market. I understand these claims completely. As a stock market analyst who has studied various "systems" or theories such as Gann or Elliott Waves Analysis, I have been mostly disappointed. To tell you the truth, a lot of these systems and theories don't really make much logical sense to me (or maybe I am just not too bright). This is the one reason why our commentaries are usually backed up by some fundamental analysis, and why even our technical analysis work is backed up by tools or indicators that are obvious and that make sense to even the first-time reader.

As far as the Dow Theory goes, it is really not a "rigid" system for analyzing the stock market. In fact, even the idea of "confirmation" (a tool which indicates the authority of the current trend) by the Dow Industrials or by the Dow Transports of the other Dow index is merely a secondary indicator, as has been claimed by figures such as Hamilton, Rhea, Schaefer, and Richard Russell of the Dow Theory Letters. It is to be noted here that the Dow Theory is merely a set of theories and observations that have evolved over time by the major students of the Dow Theory (hopefully myself included). The only "rigid" assumption that could be spoken of is the concept of the valuation cycle - that the market swings from undervaluation to overvaluation and then back again. However "rigid" that is, it is to be said here that this valuation cycle has clearly been observed both the leading stocks and in the major stock market indices all across the world ever since the capitalist system was born. Moreover, like I said before, the valuation cycle is very similar to the business cycle - as both investors and consumers tend to swing from extreme optimism to extreme pessimism and back again. In my opinion, this makes the Dow Theory much more credible than many of the other theories or "systems" out there being used to forecast future stock price movements.

For readers who accept this view, then I believe there is no doubt or disagreement that a secular bull market ended in early 2000 when the Dow Jones Industrial Average made an all-time high without an upside confirmation by the Dow Transportation Average. This non-confirmation was made the more authoritative given the fact that it occurred within the third phase of the bull market - a phase where retail investors speculated in the stock markets en masse - finally ending with a huge "blowoff" in both the NASDAQ and the S&P 500, and taking valuations well above their previous 1929, 1966, and 1987 peaks. If one assumes that, then a great secular bear market has already started five years ago - which had been briefly interrupted since October 2002 by a cyclical bull market which is now very mature. If this theory holds, then by far, the best comparison between the current secular bear market is the eight-year secular bear market from 1966 to 1974 - a comparison which I have made countless times in the past and which I will make again later in this commentary. For now, let's review the most recent daily action of the Dow Industrials vs. the Dow Transports which we will use as a basis for such a comparison. Please keep in mind that there is a lot of analyses to be made here:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (July 1, 2003 to June 24, 2005) - 1) The Dow Transports failed to confirm on the downside - which ultimately carried bullish implications for the Dow Industrials! 2) The implications of the negative divergence on the part of the Dow Transports that I have been discussing for the last couple of weeks suddenly came to fruition on the last two trading days of the previous week - with the Dow Transports declining 157 points and the Dow Industrials declining 290 points during those two days.  For the week, the former is down 5.0% while the latter is down 3.1%.  It has also been nearly four months since a PRIMARY NON-CONFIRMATION occured in early March - when the Dow Industrials FAILED to confirm the all-time high in the Dow Transports.  The chances of the Dow Industrials confirming the Dow Transports on the upside (by making an all-time high) anytime soon also do not look very high.

First of all, the most recent negative divergence by the Dow Transports proved very ominous, with the Dow Industrials declining 290 points and the Dow Transports declining 157 points during the last two trading days of last week - a potential development that I have been warning about for the last couple of weeks. Furthermore, this development would prove far more ominous if the Dow Transports is to decline below its most recent closing low of 3,382.89 made on April 15th - a level which is currently only 29 points away on the downside.

More important, however, is the PRIMARY NON-CONFIRMATION by the Dow Industrials of the Dow Transports - when the latter made an all-time high of 3,872.17 on March 8th while the Dow Industrials failed to confirm this all-time high (a DJIA closing high of 11,723.00 which was made on January 14, 2000) by a whopping 800 points. Nearly four months has been passed since this primary non-confirmation, and chances are that the Dow Industrials will not confirm on the upside anytime soon, especially given its most recent decline. So what are the potential implications? Let's play Devil's advocate here and make a comparison between the current scenario to the 1966 to 1974 scenario - covering the October 1966 to 1968 and the May 1970 to 1972 cyclical bull markets in the process.

I will first post the daily chart of the Dow Industrials vs. the Dow Transports during the January 1968 to December 1969 period - a period which covered the last part of the October 1966 to 1968 cyclical bull market and the beginning of the 1969 to May 1970 cyclical bear market - all within the 1966 to 1974 secular bear market. What is the main similarity between that cyclical bull market and the current cyclical bull market (besides the fact that they both occurred within a secular bear market)? Make a guess, but if you want to know the answer quickly, then just scroll down towards the bottom or below the following chart:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (January 1, 1968 to December 31, 1969) - 1) A PRIMARY Dow Theory non confirmation occured in December 1968 when the Dow Transports made an all-time high while the Dow Industrials failed to concurrently make an all-time high (the Dow Industrials was ten points away from surpassing its all-time high of 995.20 made in February, 1966).  The subsequent underperformance of the Dow Industrials over the next two months proved very ominous, indeed. 2) Double top and lower high in the Dow Transports and a huge underperformance in the Dow Industrials!

Answer: The October 1966 to 1968 cyclical bull market ended with a PRIMARY NON-CONFIRMATION by the Dow Industrials of the Dow Transports - when the Dow Transports made an all-time high in December 1968 without the confirmation of the Dow Industrials on the upside. This non-confirmation proved very ominous, as it literally signaled the end of the October 1966 to December 1968 (a period spanning 26 months) cyclical bull market. The watershed decline in the Dow Transports occurred about two months later, while the Dow Industrials would hold up well until mid-May - a full five months after the primary non-confirmation. It is also interesting to note that from the bottom in October 2002 to March 2005, the cyclical bull market has lasted approximately 29 months - a very similar length to that of the October 1966 to December 1968 cyclical bull market.

Now, let's fast forward a few years and take a look at the next cyclical bull market within the 1966 to 1974 secular bear market - the May 1970 to December 1972 cyclical bull market. Following is a daily chart of the Dow Industrials vs. the Dow Transports covering the January 1972 to December 1973 period - which covers the latter part of the May 1970 to December 1972 cyclical bull market as well as the subsequent cyclical bear market:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (January 1, 1972 to December 31, 1973) - A PRIMARY Dow Theory non confirmation occured in January 1973 when the Dow Industrials made an all-time high while the Dow Transports failed to concurrently make an all-time high (nine months earlier, the Dow Transports was 3.8 points away from surpassing its all-time high of 279.5 made in December 1968).  The fact that the Dow Transports severely lagged the Dow Industrials over the last nine months proved very ominous - a precursor to the 1973 to 1974 bear market.

You guessed it - the similarity is still there. Please note that the demise of this cyclical bull market coincided with a PRIMARY NON-CONFIRMATION - this time with the Dow Transports not confirming the all-time of the Dow Industrials made on January 11, 1973. The two major Dow Indices (and especially the small and mid cap stocks) subsequently experienced a relentless decline until a slight bounce in the Fall - a relentless decline which would not end until late 1974. This cyclical bear market finally ended with the P/E of the Dow Industrials at six, accompanied by a dividend yield of 6%. Again, interestingly enough, the May 1970 to 1972 cyclical bull market last for a period of 31 months, just slightly longer than the 29 months that we enjoyed from October 2002 to March 2005. Of course, I guess I don't need to remind our readers that we are now in June - which means that the bull is now officially overstaying its welcome if we are to follow the 1966 to 1974 secular bear market scenario.

Darn, Henry - are you saying that the cyclical bull market is now over?

I am definitely not, but it is interesting to note that none of the popular commentators have even mentioned this possibility recently. Not even Richard Russell - the "dean" of the Dow Theory. Readers who have kept up with my commentaries will know why I haven't so far called an end to this cyclical bull market yet. The reason? Simply because we have not experienced a final "blow off" phase yet - a phase which is characterized by massive speculation from retail investors and from complete disregard for valuations. I still believe that we will see such a "blow off" before we see a resumption of the secular bear market, but for now, it really doesn't matter if the cyclical bull market has ended or not yet, since I believe we are now on the right side of the market. As soon as I see a potential rally develop (whether that rally will turn out to be that "blow off" rally or not), I will alert our subscribers and shift to a more bullish bias.

Look - the Dow Theorist Richard Russell called an end to the great 1974 to 2000 secular bull market on the basis of a PRIMARY NON-CONFIRMATION by the Dow Transports of the Dow Industrials (characterized by the fact that we were in the third and final phase of the secular bull market) during September 1999 - only six months before the final "blow off" of the NASDAQ Composite and the S&P 500. My point is: A "blow off" rally to signal the end of this cyclical bull market can still occur even after the "official end" of the cyclical bull market as defined by the Dow Theory. Our intent is capital preservation and then profits - and the recent action in the Dow indices (as interpreted by the Dow Theory) and in other technical indicators that I have been keeping track suggests that we should take more defensive action here.

Readers should now note that we switched from a 50% long position in our DJIA Timing System to a completely neutral position on the morning of June 13th - a full two weeks ago. While I acknowledged that we were probably a little early, I still stand by this position - primarily because I did not feel that our picks (large cap growth and brand name companies, such as YHOO, EBAY, SBUX, MRK, KO, etc.) would do well going forward from that point. The action of the last two weeks (and especially late last week) has proven that our fears were correct. As outlined in a short post that I wrote in our discussion forum last Friday morning, I now believe probability favors the downside - even if you're a great stock picker. As I mentioned in that post, this view of mine going forward is confirmed by the NYSE McClellan Oscillator finally (and convincingly) declining below the zero line - a condition which it has not been in since mid-April earlier this year. Following is a chart of the NYSE McClellan Oscillator along with the Summation Index courtesy of Decisionpoint.com:

Note that the NYSE McClellan Oscillator has now convincingly declined below the zero line - something which it hasn't done since mid-April! Please also note: The Summation Index is definitely very overbought and is now in the process of turning down!

The fact that the NYSE McClellan Oscillator has finally declined below the zero line, and coupled with a very overbought Summation Index suggests to me that not only breadth will decline going forward, but that we are still a relatively long way away from the bottom. It is not pretty, but this is what I am currently seeing.

A great many "gurus" and financial market analysts are now calling for a stop to the Fed's rate hikes as early as a 3.25% Fed Funds Rate, but most probably at 3.50%. They also claim that this is the reason why the stock market has rallied recently. I am not sure if this is true or not (and neither is anyone else), but I am convinced that if the Fed does halt its rate hikes (perhaps we could see some language about the possibility when the Fed meeting ends this Thursday, but if don't, then the bulls will need to wait until August 9th before we could see any potential relief), we should be able to see it in the performance of the Philadelphia Bank Index - which historically has been a great leading indicator of the overall stock market. Judging by the most recent action of the Bank Index, however, it is not obvious to me, as the Bank Index - while it is above its 50-day moving average - is still below its 200-day moving average, and is only 0.54 points away from breaking below that 200-day moving average. Is that two-month bounce off the eight-month low in mid-April suggestive of an end to rate hikes at a 3.50%? Perhaps, but I am not willing to bet on it right now.

Perhaps a better reading of the Bank Index can be gleaned by looking at a relative strength chart of the Bank Index vs. the S&P 500. I have shown this chart periodically in our commentaries - and I apologize since I probably haven't updated the chart as often as we should have. Without further ado, following is the weekly relative strength chart of the Philadelphia Bank Index vs. the S&P 500 from February 1993 to the present:

Relative Strength (Weekly Chart) of the Bank Index vs. the S&P 500 (February 1993 to Present) - 1) The last time the relative strength of the Bank Index broke down in a significant way was during the July 1998 period - and we all know what happened afterwards. 2) The decline in relative strength of the Bank Index after the LTCM and Russia crisis and during 1999 suggested tougher times ahead for the U.S. stock market -- and in retrospect, it was cold-bloodedly right. 3) Relative strength of the Bank Index finally broke through support convincingly 18 weeks ago and and has stayed down since - with the exception of a back-kiss off the same line eight weeks ago.  The threat of a liquidity crunch continues to be profoundly high unless relative strength of the Bank Index can break through this resistance line sometime in the next few weeks.

Long-time readers should be somewhat familiar with this chart and the history of the relative strength of the Bank Index vs. the S&P 500. Please note that historically, the action of the relative strength of the Bank Index has cold-bloodedly foretold any developing liquidity crunches as well as any subsequent declines in the stock market. Please also note that the relative strength of the Bank Index declined below its two-year support line 18 weeks ago and has stayed down since despite the most recent two-month rally. This suggests that the U.S. cyclical bull market is now in danger. Ironically, in a liquidity crunch scenario, the U.S. tends to fair the best - meaning that emerging market stocks/bonds are still a "sell" as well as commodities like steel, lumber, copper, and (gasp!) crude oil and natural gas. We will find out soon enough. (As an aside, the action of the Dow Transports and crude oil and oil stocks has had a very good positive correlation over the last few years. Since the Dow Transports is now probably in an intermediate-term decline, I believe the chances of crude oil and oil stocks continuing to enjoy a sustainable rise here is pretty slim.)

Since this commentary is (again) getting too long already, let's now end it with a discussion of our most popular sentiment indicators. I will start off with the chart showing the Bulls-Bears% Differential in the American Association of Individual Investors vs. the Dow Industrials:

DJIA vs. Bulls-Bears% Differential in the AAII Survey (January 2003 to Present) - The Bulls-Bears% Differential in the AAII survey remained steady at 29% this week - consolidating at the 25% to 30% range over the last four weeks and in the process working off its hugely oversold condition made during April. On a ST basis, it is still overbought, with the 10-week moving average increasing slightly from 6.6% to 12.3% - still oversold on a longer-term basis.  Please keep mind that that the most severe stock market declines have occured in the face of an oversold reading in the AAII Bulls-Bears% Differential.

As shown on the above chart, the Bulls-Bears% Differential in the AAII Survey remained steady at 29% this week - a ST slightly overbought level. The fact that this indicator has been consolidating at the 25% to 30% level over the last four weeks suggests to me that this indicator (in the longer-term sense) is not longer as oversold, even though the ten-week moving average is still only at 12.3%. Again, keep in mind that the most severe stock market declines have occurred in the face of an oversold reading in the AAII Bulls-Bears% Differential.

The Bulls-Bears% Differential in the Investors Intelligence Survey is also telling the same story - with a slightly higher reading this week from 32.3% to 33.7% - ST overbought even as the ten-week moving average is still only at 22.38%:

DJIA vs. Bulls-Bears% Differential in the Investors Intelligence Survey (January 2003 to Present) - The Bulls-Bears% Differential in the Investors Intelligence Survey again increased slightly from 32.3% to 33.7% in the latest week - still in a slightly overbought situation.  However, the 10-week moving average is still at 22.38% - still one of the most oversold readings over the last 18 months.  However, the 10-week moving average is due to move higher, as the four-week moving average is already now at 29.6%.  We will not initiate any long positions again until this survey has declined to a more reasonably oversold level.

There is really not much to say here - except for the fact that we will now only use the two above indicators as "oversold" indicators and nothing else. That is, we will not initiate any long positions in the stock market until these two surveys have reached a more reasonably oversold level, such as the oversold levels that we were witnessing during mid to late April.

By far, the most "accurate" of our three popular sentiment indicators has been the Market Vane's Bullish Consensus, as it stayed overbought at over 55% over the last 18 months - suggesting that any rally that developed would be mediocre at best. In retrospect, this indicator was cold-bloodedly right:

DJIA vs. Market Vane's Bullish Consensus (January 2002 to Present) - 1) The 50% line 2) The Market Vane's Bullish Consensus increased yet further from from 69% to 70% in the latest week - equaling the most overbought readings since November 1998.  Over the last five weeks, the Market Vane's Bullish Consensus have registered readings of 67%, 67%, 68%, 69%, and 70% respectively - rendering this survey in very overbought territory.  Coupled with the most recent action in the stock market over the last week, this indicator is suggesting that we still have a long way to go before we can label this market as oversold.  For now, I will not initate any long positions here until this survey has gotten to a more oversold level of, say, 60% or below.

The latest reading of 70% on this survey suggests to me that the market is still very much overbought - despite the latest correction over the last two trading days. Like the AAII and the Investors Intelligence Survey, this indicator should now be solely treated as an "oversold" indicator and nothing else. For now, we will not initiate any long positions in the stock market at least until this reading has declined to a more "manageable" level of 60% or below. Long-time readers will know that my optimal oversold reading is at around the 50% level, although I have been waiting for such a reading for months. Perhaps we will get one such reading this time?

Conclusion: The Summer/Fall correction that I have been looking for during the last few weeks is finally coming to fruition. Is this a normal, run-of-the-mill correction or is it something more serious? My studies of the Dow Theory now suggest the latter, given the extent of the primary non-confirmation and the slowing economy. Even if one does not subscribe to the tenets of the Dow Theory, it is important to note here that this latest cyclical bull market cycle is now maturing, and chances of one making money on the long side are now declining as each day passes by. That being said, I am still looking for that one "blow off" rally" - a rally which tends to end all bull markets to occur within the next three to five months. For now, we will remain neutral, as the market has run away from us on the short side. We will also not initiate any long positions again until our three popular sentiment indicators have reached a more oversold level - which is still a long way away given my experience and the history of those indicators.

Signing off,


 

Henry To

Author: Henry To

Henry K. To, CFA
MarketThoughts.com

Henry To, CFA, is co-founder and partner of the economic advisory firm, MarketThoughts LLC, an advisor to the hedge fund Independence Partners, LP. Marketthoughts.com is a service provided by MarkertThoughts LLC, and provides a twice-a-week commentary designed to educate subscribers about the stock market and the economy beyond the headlines. This commentary usually involves focusing on the fundamentals and technicals of the current stock market, but may also include individual sector and stock analyses - as well as more general investing topics such as the Dow Theory, investing psychology, and financial history.

In January 2000, Henry To, CFA of MarketThoughts LLC alerted his friends and associates about the huge risks created by the historic speculative environment in both the domestic and the international stock markets. Through a series of correspondence and e-mails during January to early April 2000, he discussed his reasons and the implications of this historic mania, and suggested that the best solution was to sell all the technology stocks in ones portfolio. He also alerted his friends and associates about the possible ending of the bear market in gold later in 2000, and suggested that it was the best time to accumulate gold mining stocks with both the Philadelphia Gold and Silver Mining Index and the American Exchange Gold Bugs Index at a value of 40 (today, the value of those indices are at approximately 110 and 240, respectively).Readers who are interested in a 30-day trial of our commentaries can find out more information from our MarketThoughts subscription page.

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