On January 23, 2023, Michael J. Burry posted a chart that we will deconstruct as it relates specifically to Dow Theory.
Above is a charting of the S&P 500 from 2000 to 2003. Burry has circled in red a potential scenario that is expected for the current market. Although it seems straightforward, there are three potential outcomes that are addressed in Dow Theory. Below we outline how to interpret the period in question.
As shown in the reposting of the chart by Burry, we can see three scenarios highlighted in different colors.
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Confirmation of Bullish Trend (green)
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Re-test of Prior Peak (blue)
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Confirmation of Bear Market (red)
First and foremost, we have to address the elephant in the room. By Burry’s own reckoning, the current declining trend of the market is almost over. On its own, this is huge. In some respects, this implies that downside risk is limited, given what we know about the market’s performance on the way to the 2007 peak. Now that we’ve gotten the wishful thinking out of the way, we now need to address what Dow Theory says about the thinking of Burry.
If the pattern seen in the yellow box looks familiar then the reason why is because earlier today we posted an article on Bitcoin that applied to Dow Theory addressing this exact same point. In our article, we said the following:
“Rangebound price activity is indicative of a potential buildup of force in the price. According to the great Dow Theorist Robert Rhea:
“Such a narrow fluctuation, to the experienced student of the averages, may be as significant as a sharp movement in either direction.”
Rhea, Robert. The Dow Theory. Barron’s (1932). page 82.
“A line, as seen in the price activity of Bitcoin from June 2022 to the present, will result in a major move at the conclusion of the move.”
Bitcoin is already in the throes of what Burry is predicting for the S&P 500. Except in the case of Bitcoin, it appears to be on the cusp of breaking out to the upside. This breakout to the upside would be a Confirmation of the Bullish Trend according to Dow Theory, represented as green in the chart.
The market activity in the box, often referred to a trading range, is what Dow called a dull market or a “line” and he has the following to say on the matter:
"The longer time, moreover, that the market remains dull the more important is the movement likely to be."
-Charles H. Dow, Wall Street Journal, October 13, 1899
In the chart provided by Burry, if the S&P 500 broke above the upper end of the range then it would be considered Confirmation of the Bullish Trend.
Confirmation of the Bullish Trend requires the price to rise from the established base to the prior peak, as represent by the blue line. In the example provided by Burry, there was the famous double top which was followed by a breakthrough to the downside which indicates more downside risk to follow.
“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.”
-Charles H. Dow, Wall Street Journal, July 20, 1901
As seen in the chart provided by Burry, the S&P 500 experienced a double top and then fell sharply to the October 2002 low. This is consistent with Dow’s claim that after a double top, the market would “decline some distance.” The opposite is usually the rule for double bottoms whereby the market would experience an increases of some distance. In this case, a rise to the January 2022 peak.
As in the Bitcoin posting from earlier today, we are obligated to anticipate the market going from the prior peak to the support levels at the bottom of the box. This isn’t a hope, it is an attempt at frontloading the right acceptance of the potential downside risk as the price approaches the upper end of the established range.
"The averages, indeed, must be read with a single heart. they become deceptive if and when the wish is father to the thought."
-Hamilton, William Peter, (4th Editor of the Wall Street Journal). The Stock Market Barometer. Harper & Brothers, New York. 1922. page 133.
A decline below the established low end of the range is a Confirmation of the Bear Market.
Where is S&P 500 Right Now?
Most important when applying Dow’s technical theory is taking a look at where we are presently. As noted in the Bitcoin article, there are both double tops and double bottoms to be mindful of. In the case of the latest activity of the market, we’ve seen a double bottom which suggests, initially, that the market is going to the most recent peak set around August 8, 2022.
Q: Does the fact that we’ve seen a double bottom mean that the market is going to a new high?
A: We can’t feel comfortable assuming that a rise from a double bottom is an automatic new high for the market. We’d like to see how strong the market breaks through on the upside, if it actually happens. At minimum, we’re in a situation that is literally the opposite of what Burry presents in his latest posting.
See Also:
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Dow Theory on Bitcoin January 23, 2023