Dow Theory attempts to define and identify major moves in markets referenced here as the “primary trend.” In this piece, we will outline the price of gold according to Dow Theory.
We’re going to review and analyze the primary trend that extends from the September 2011 peak to the currently established low in the price of gold in December 2015. We believe that this information is critical to understanding where we are and where we might be going. This interpretation is based on the work of Charles H. Dow, co-founder of the Wall Street Journal and namesake to the longest continuous stock market indexes.
Keep in mind that all of the analysis that follows is done in generalities so that an individual who is curious about Dow Theory can refer to the technical manual on the topic titled The Dow Theory by Robert Rhea. However, the true heart of Dow’s theory is found in his original writing which covered the topic of earnings, dividends, effect of dilution of shares and economic outlook AND NOT lines on a chart. Two books that cover Charles H. Dow’s work as a fundamental analyst and an adept economist are titled Dow Theory: Unplugged and Charles H. Dow: Economist, respectively.
A Look Back
It is necessary to outline the history of primary trends in the price of gold to ensure clarity of where we are coming from and where we might be now. Below is a graph of the price history of gold with the primary trends.
The dates for the primary trend indication are as follows:
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December 1969 at $35.17
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December 1974 at $188.25
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August 1976 at $104.20
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January 1980 at $760
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August 1999 at $255.35
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September 2011 at $1,895
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December 2015 at $1,049.40
The percentage change for the primary trend indications above are as follows:
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I: +435%
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II: -45%
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III: +629%
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IV: -66%
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V: +642%
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VI: -45%
Dow Theory Primary Trend Analysis at VI
Going over the general indications, we can easily see that, from the available data, the average increase in the primary trend is +568%. Likewise, the average decline in a primary trend is –52%. Unfortunately, we don’t get the benefit of living in the world of averages. It has always been our contention that as investors we’re going to experience the extreme on the downside and maybe the average on the upside. The concept of accepting the extreme on the downside (or worst case scenario) is derived from Dow’s April 27, 1899 commentary in the “Review and Outlook” section of the Wall Street Journal as follows:
"The point of importance for those who deal in industrial stocks is whether the capitalization of the companies into which they propose to buy is moderate or excessive, when compared with the aggregate earnings of the various concerns forming the combination in a period of depression. It is probable that consolidated companies will be able to earn as much in the next period of low prices as the companies forming the combine were able to earn in the last one; hence the very foundation of investments in industrials should be knowledge of what these companies earned, say in 1893 to 1896, making, perhaps, reasonable allowances for economies under consolidation. Where the earnings so shown would have provided dividends for industrials now active, the fact must be regarded as a very strong point in favor of those stocks (George W. Bishop Jr., Charles H. Dow: Economist, Dow-Jones & Company,Princeton, 1967, page 11.)"
According to Dow, as an investor, you must base your current investment decision on the last “…period of depression.” For us, on the topic of gold, that last relative period of depression was at the 1999 low, which saw a decline of -66% from the 1980 peak. So far, we’ve seen a decline in the price of gold from the 2011 peak to the 2015 low equal to approximately -45%. This implies that in the worst case scenario, we should not be surprised to see gold decline to $630.70.
Within the context of a decline of nearly –66%, investors and speculators need to be prepared to seize opportunities as they arise. In all instances of a declining trend, there will be periods when the market will rise almost in defiance of the fear. Likewise, in a rising market, there will be periods of decline in the face of rampant greed. In the particular case of gold and its declining trend since 2011, Dow addresses the issue of possibly achieving average returns on the upside with the following comment:
“The market is always responsive to the great law of action and reaction. The longer the swing one way the longer it will be the other. One of the best general rules in speculation is the theory that reaction in an advance or a decline will be at least one-half of the primary movement [50% principle].
“The fact that the law is working through short ranges and long ones at the same time makes it impossible to tell with certainty what any particular swing may do; but for practical purposes, it is not infrequently wise to believe that when a stock has risen 10 points, and as a result of one or two short swings [double tops] does not go above the high point, but rather recedes from it, that it will gradually work off 4 or 5 points (Dow, Charles H. Wall Street Journal. October 19, 1900.).”
In another excerpt from Dow’s work, on the topic of achieving average returns, Dow says:
“It often happens that the secondary movement in a market amounts to 3/8 to ½ of the primary movement (Dow, Charles H. Wall Street Journal. January 22, 1901.).”
Long before anyone was actively writing on the topic of Fibonacci numbers being applied to the movement of stock prices in the United States, Charles Dow was already apply the concept as part of his theory. The perspective on downside expectations, at least according to Dow, are that a protracted decline will have, at the very least, a reversal to the upside, approximating between 37.50% to 50% of the prior decline, which is the inverse of the examples above.
As an investor, assuming the primary trend is still in place, you can expect that the market will react (move opposite of the primary trend) between 37.50% to 50%. To refresh, the price of gold peaked at $1,895 in September 2011 and declined to $1,049.40 by December 2015. A 37.50% to 50% increase of the previous decline would bring the price of gold up to between $1,351.50 and $1,472. The recent increase in the price of gold from $1,049 to $1,366 fits nicely into what an investor should expect in a normal declining trend. The decline in the price of gold from $1,366 in July 2016 will be the true test of whether the rise since December 2015 is merely a reaction or a reversal of the primary trend.
The punch line to the period from the peak in the price of gold from 2011 to 2015 is that at a -45% decline, the drop has not been out of the ordinary and is very close to the long term historical averages. The challenge becomes, how do we identify when/if the pendulum swings from a bearish primary trend to a bullish primary trend?
From Bear to Bull or Back to Bear Again
As previously indicated, the current declining trend may not have been exorcised as the last "period of depression" saw a decline of -66%. However, there is no rule that this time has to see the exact same decline as 1980 to 1999, only that we set our expectations to the last decline as our own worst case scenario. Understanding that the current declining trend may still be in place, we'll attempt to identify the characteristics of a trend reversal based on the recent price action.
Going back to the first chart and reviewing the primary trend indicated as “VI”, we will point out the nuances that speculators and investors should be watching. The chart below outlines the period from the peak in the price of gold at $1,895 to the most recent low at $1,049.
Again, according to Charles Dow, a primary trend is fraught with secondary reactions which range from 3/8 to ½ of the primary trend. This secondary reaction is indicated in the chart above as “Z1” where the price of gold had attained the $1,366 level. Interestingly, the price of gold retraced 37.48% ($317) of the total decline ($846) from 2011.
It is not enough for the price of gold to simply move higher for us to believe that the primary trend has changed from bearish to bullish. Dow points to what he expects to see at the conclusion of a primary trend, in this case at the end of a bull market:
"Another method is what is called the theory of double tops. Records of trading show that in many cases when a stock reaches top it will have a moderate decline and then go back again to near the highest figures. If after such a move, the price again recedes, it is liable to decline some distance (Dow, Charles H. Wall Street Journal. July 20, 1901.)."
The inverse of the “theory of double tops” is to see a low in the price for gold ($1,049) followed by a reaction ($1,366) then a possible retest of the low (so far at $1,126). The visualization of the reversal pattern of a double to and bottom is best illustrated in Dow Theorist Richard Russell’s mechanical plotting of a primary reversal as applied to the Dow Jones Industrial Average and Dow Jones Transportation Average.
For the sake of clarification, the price of gold could decline below $1,126 and, if remaining above $1,049, could still be considered to give a bullish primary trend indication when/if it exceeds the $1,366 level (as represented in Figure 1a & 2a). Figures 1b and 2b are not ideal scenarios for how a reversal in the gold market could emerge as a very small percentage of these types of configurations emerge as valid indications and the sense of a false indication is all to easy under such circumstances.
To hammer home the point on what we’re looking for, we have included the technical outline for a bull and bear primary trend indication from Sparta Fritz and A.M. Shumate’s series on Dow Theory in Barron’s from August 1939 to October 1939:
The above chart is more specific as to what a Dow Theorist would like to see. Again, an ultimate low followed by a rise then a retest of a decline to “point 1” and a rise above “point 2”. So far, in the price of gold, $1,049 represents the ultimate low, $1,366 represents the rise from the low, $1,126 represents (so far) the “point 1” while the verdict is out on whether we go above “point 2” which is represented by $1,366 or fall below $1,049.
If the price of gold declines below the $1,049 level then it would be safest to assume that the trend is down until a new trend reversal pattern is established.
Caveats and Afterthoughts
When looking at a “primary trend” after the fact, we can always be right in timing and extent. However, Dow Theory has its limitations, chief among those limitations is the person doing the analysis. There are countless number of ways an analyst could get the interpretation of Dow Theory wrong.
Another limitation is the connecting of the actual primary trend to the primary trend as indicated by Dow Theory. Any true observer of Dow Theory could not call the very bottom in the market if they are willing to wait for the confirmation of the trend by seeing gold increase above $1,366. As an example, our own call of a primary trend bull market came on July 23, 2009. Our profound divination of the fact that a bull market was in force (probably quite obvious to many without the use of Dow Theory) meant missing a +39% increase in the general market from the March 2009 low.