Category Archives: Dow Theory

Dow Theory: The Formation of a Line

Posted on September 8, 2010 by | Leave a comment
According to Dow Theory, the formation of a line, the stock market trading in a narrow range, typically portends a major movement in the market once the range is broken through on the upper or lower end of the channel it has traded in. To be specific, Dow Theory indicates that a line is created when both the Dow Jones Transportation and Industrial Averages are in a range of 5% over a period for 8 weeks or more.
 
In the charts below, neither index has exhibited a narrow range of 5% or less. In addition, from a strictly technical basis, it would be difficult to say that a range has not been broken on the upside in March and April of 2010 for the Dow Jones Industrial Average or the downside in July 2010 for both indexes. However, it is challenging to ignore the general range of 10,700 to 9,750 that the Dow Industrials has traded in since late September 2009. Likewise, the Transportation index has traded in a fairly tight range since mid-May 2010.
Saved for the exactitudes of Dow Theory, I believe that we’re witnessing an over-extended “line” as defined by William Peter Hamilton. Hamilton said of lines:
 
“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.
This suggests that a range bound market is the equivalent to a stock market crash. It is hard to quantify what the extent of the crash would look like if it took place instead of trading in a range. However, we could compare the range to the crash from October 2007 to March 2009 with the current market in terms of time. In the period from 2007 to 2009, it took approximately 17 months to flush out the weakness. The current market is bordering on 12 months of relative inaction.
 
If this is a correct assessment, then the price of the market must have approached some sort of alignment with the values of the market. Therefore, a rise above the upper end of the line could represent a “sudden” realization that the current market is ridiculously undervalued.
 
Conversely, if the weakness of the market hasn’t been wiped out of the market over the last 12 months then a slump to the downside could be devastating since a verdict indicating that we’re still overvalued would awaken investor’s worst fears about all the headlines of an economy that is getting by on dwindling government (i.e. Federal Reserve) life support.
 
If the pattern of a line formation is not correct then the alternative view could be that we’re witness to a classic head-and-shoulder formation in the Dow Jones Industrial Average with the head being April 2010 and the shoulders being January and August 2010. My suspicion is that, like the pendulum on a clock, the areas in red are only reactions to the prior extremes and therefore offset the otherwise technical relevance of each extreme. Basically, the April-May extremes were counteracted by the July extremes rendering the significance of each period null and void.
 
The further the markets continue in this range the greater the impact it will have once that range-bound action is broken. However, the length of time that has been spent in such a range seems to indicate that we’re due for a breakdown or an explosion if the markets cross below or above the range.
 
This is one instance where the outcome of a 50/50 proposition could have a dramatic effect on the short-term economic decisions of our nation. Politicians vying for re-election will fight tooth-and-nail against outcomes that don’t “appear” positive. With this in mind, it is possible that the only option is to the upside. We say this with a note of grudging acquiescence since we would rather opt for what is restoring and regenerative instead of what is expedient.
 
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Dow Theory, Stock Markets and Economic Forecasting

Posted on August 5, 2010 by | Leave a comment
A reader writes:
In a recent Time Magazine article dated July 27, 2010, David Rosenberg said the following:
 

"…But the market gets it wrong as often as it gets it right – it was wrong to forecast a recession in the fall of 1987, again in the summer of 1998 and again in the winter of 2003. It was wrong to forecast sustained growth in the summer of 2000, a recovery in the winter of 2002, an avoidance of recession in the fall of 2007 and the end of the downturn in the spring of 2008. It may be a discounting mechanism, but the stock market has a spotty record – let's remind ourselves of that."

Does this mean that the Dow Theory was not giving the right signals for the stock market during all the periods Rosenberg mentions above? Can you tell me what was Russell saying with regards to the stock market's and the economy's trend as forecasted by the Dow Theory during those periods?
 
To put it another way, there are two separate issues involved here:
 
  • First, does the Dow Theory correctly forecast the bull/bear trend reversals in the stock market? (Answer seems yes, though with a considerable lag.)
  • Second, does the stock market correctly forecast recoveries/recessions in the economy? (Some say No!)
Our Response:
To address the preceding questions, we’ll first cover the role of Dow Theory from our perspective. Then we’ll address the aspect of modern usage of Dow Theory from the leading proponents with the widest following. Then we’ll circle round to address Dow Theory and how to make it useful regardless of its obvious shortcomings. We’ll address Richard Russell’s take on Dow Theory and what he was saying about the market using Dow Theory. We’ll make comments on David Rosenberg’s assessment that the stock market “…gets it wrong as often as it gets it right” by comparing the periods of recession with the Dow Jones Industrial Average.
 
When thinking in terms of Dow Theory, the New Low Observer team doesn’t take the conventional view on how it should be used. To us, Dow Theory isn’t a market forecasting tool as much as it is an allocation indicator. When there is a bull market indication then we have a target allocation of 33% or more for a single stock. When there is a bear market indication then we have a target allocation of 25% or less for an individual stock.
 
Some take Dow Theory too seriously and extrapolate far beyond even the most rudimentary use and allow it to become a make or break approach for buying or selling stocks. The most useful, but least understood, element of Dow Theory is Charles Dow’s discussion of values. Subsequent writing on the topic of values, in the context of Dow Theory, by Nelson, Hamilton, Rhea, Collins, Shumate, Schaefer, Russell and Schennep are worth heaps more than any successful market call of a top or bottom. In fact, the Dow Theory understanding of values trumps all market signals since great values can exist in both bull and bear markets.
 
Aside from ignoring the emphasis on values, the two most common mistakes that are made when thinking about Dow Theory are misinterpretation and misapplication. Accurate interpretation is the primary goal of every Dow Theorist. However, it becomes easy to get overwhelmed with current market conditions. This makes the acceptance of what the indicator is saying very challenging. Front load a few personal experiences from the “Great” Depression and WWII and it become impossible to see the market from the trees. Renowned Dow Theorist Robert Rhea once cautioned those trying to interpret the markets (especially Dow Theory) that, “the wish must not father the thought.” In many cases, it becomes too easy for the wish to supercede the judgment of markets.
 
The linked article written on June 16, 2010 on MarketWatch.com titled “Avoiding a Death Sentence” by Mark Hulbert provides a perfect example of misinterpretation and misapplication when trying to use Dow Theory. We get misapplication by trying to recommend selling stocks based on the misinterpretation of a potential bear market indication.
 
In the article, Hulbert highlights opinions on Dow Theory from the most prominent Dow Theorists today starting with Richard Russell, Jack Schannep and Richard Moroney. The basic view in the article was that the stock market was grasping at the last straws of a bull market and it was only a matter of time before a sell signal would to be given.
Richard Russell was the only one of the three Dow Theorists who was unwavering in his view that a sell signal had already been registered. The article quotes Russell as saying that, “the curse is cast. …[The breaking of the May lows] means that the primary bear market is resuming. The monster is creeping towards Bethlehem.”
 
Schannep and Moroney seemed to be in agreement that a violation of the June 7th low would be what they needed to see in order for them to officially declare that a sell signal had been indicated, according to Dow Theory. As it happens, the June 7th lows were violated for both the Dow Industrials and Dow Transports (on a closing basis) which means that both Dow Theorists would have given sell recommendations to their newsletter subscribers.
 
The misinterpretation of Dow Theory that was executed by these three theorists was a function of two distinct issues. First, there wasn’t a focus on prior action as suggest by Charles H. Dow. Our May 13th article on Dow Theory outlined the specific action that should be watched for prior to the occurrence based on the Dow Industrials movement from January 19th to February 5th. The next item that was misinterpreted was the May 6th “flash crash.” The fact that the Dow Industrials and Dow Transports had similar closing lows of May 6th made the otherwise technically significant closing price unimportant in comparison to the intra-day low. The intra-day low reflected either the psychological influence needed to fall as much as it did or the psychological influence needed to recover from such a low.
 
These are the factors that I think contributed to the misinterpretation of the signals given. Some Dow Theorists have said that because they take an arms length approach to the market (i.e. not invested personally in stocks) that their interpretation is not clouded by the desires for financial gain. However, those same Dow Theorists manage to get it wrong just as often as anybody else.
 
Next is the issue of the misapplication of Dow Theory. William Peter Hamilton was correct in titling his book on Dow Theory The Stock Market Barometer. Like a weather barometer, Dow Theory was intended to be a guide to the direction of the market on a short-term basis. The readings from a weather barometer tell you to either bring an umbrella or leave it at home. The barometer never tells you to stay at home if it is going to rain. Telling investors that a bear market has been signaled and therefore you need to sell all or some of your stocks is the equivalent of saying, “its going to rain today, you’d better stay home.”
 
Again, Dow Theory wasn’t intended to generate a buy or sell indication. Instead, it was created to tell investors what the current conditions of the market are with a 3-month, 6-month, or 9-month peek at what might lay ahead. If the indication is that we’re in a bear market then we could expect that the market will decline further. If the indication is that we’re in a bull market then we could expect that the market will rise. What an investor does with this information is something else altogether. In many respects, buy and sell reactions based on Dow Theory bull and bear market indications are misapplications of the theory.
 
Throughout the writings by Rhea and Hamilton, it has been noted that Dow Theory is not a “get rich quick” way to make money in the stock market. Neither is the theory infallible. Because misinterpretation of Dow Theory is so easy to accomplish, the New Low Observer team attempts to focus more attention on values and the application of Dow Theory as an asset allocation tool rather than being right about the big picture or primary trend.
 
When you combine the effects of misinterpretation with misapplication by some of the most renowned Dow Theorists, it is no wonder that critics complain that Dow Theory is archaic. However, put in its proper context, observations in Dow Theory can provide better judgment in selecting individual stocks at appropriate times with proper allocations. Although Dow Theory generally gets it right about the stock market direction on a short term basis, I personally wouldn’t rely on the market calls as much as I do with Dow’s writings on values.
 
Like most market participants, we don’t necessarily know values in the way that someone as smart as Warren Buffett might. However, everyone is clear on the fact that well established companies with consistent dividend increasing histories near a new 52-week low are most likely to be closer to “real” value propositions instead of stocks in a well established rising trend or at a new high. Charles Dow was very clear that values, above all else, determine the direction of the market. This includes the values that can be found within a bull or bear market.
 
In regards to Richard Russell’s commentary on Dow Theory, it is necessary to take Russell’s bias into account when determining whether he was wrong or right about the markets in 1987, 2000, 2002, 2003, 2007, and 2008. Russell’s bias is infinitely and always to the downside and this bias has grown as time has passed. This is what makes his late 1974, early 1975 call of a market bottom so amazing and worth studying.
 
Despite being right at the time, it is next to impossible to say whether Russell truly called the tops of 1987, 2000, 2007, and 2008 or was continuing with his downside bias (false positives). However, what we can gather from each call of a market top are the nuances that are very distinct from the other times that Russell was bearish. You’d have to read all of his letters from the beginning of a rising market to the peak to know the distinctions.
 
How biased against the upside is Richard Russell, despite what Dow Theory and his proprietary Primary Trend Indicator says? The following quote should summarize Russell’s attitude.
 
“In his latest mailing, Steve [Leuthold] talks about secular bear markets. What’s a secular bear market? They are the really big ones. Steve tells us that the dictionary defines secular as ‘coming once in an age.’ Steve Leuthold says that in 46 years in this business, he has only seen two secular bear markets, the bear market of 1969 to 1974, and the bear market of 1999 to 2002. Fair enough. But I disagree. Writing at the time, I called the bear market as starting in 1966, not 1969, but Steve and I both agree that the secular bear market ended with the crushing market collapse of 1973-1974. We both agree that another secular bear market began in 1999. Steve believes that bear market ended in 2002. But I believe the bear market that started in 1999 is still in force, although it’s been extended due to the manipulations of the Federal Reserve under Alan Greenspan.”
Richard Russell. http://www.dowtheoryletters.com, staff2@dowtheoryletters.com, Letter 1378, November 17, 2004, Page 3
Even though the market bottomed in October 2002 and Dow Theory signaled a bull market in June 2003, Russell stuck to his bearish view. In his July 19, 2006 letter, Russell said, “The Big, Big Picture is this-the bear market that began in January 2000 never ended.” Russell did not indicate that we were in a bull market until January 2009. Russell managed to ignore the Dow Theory signal that was given in June 2003 at around the 9000 level for the Dow Industrials all the way to the peak in 2007 at 14,100. A span of 4 years and 55% wasn’t enough to convince Russell that the last bear market had ended. As I mentioned before, out of the blue we got the January 2009 bull market call by Russell, which seemed, at the time, to defy all available data and logic.
 
The comment posed by David Rosenberg, in the July 27th issue of Time Magazine, “that the markets continuously get it wrong,” is certainly a matter of subjectivity. Rosenberg’s assessment could be very accurate if viewed from the perspective that the popular media outlet’s parade of talking heads, representing the voice of the market, got it all wrong beforehand. However, if viewed from a Dow Theory perspective, especially in retrospect, the message that the market was sending was very clear and quite accurate, albeit somewhat delayed. Naturally, Dow Theory isn’t perfect but the consistency, as compared to the alternatives, is enough to give a general overview of future market activity that is later support by some, not necessarily all, economic indicators.
 
To be specific with Rosenberg’s contention, let us get the data portion on recessions during secular bull and bear markets out of the way. Below is a side-by-side comparison of the National Bureau of Economic Research (NBER) account of economic peaks to troughs (recessions) and the Dow Jones Industrial Average of peaks to troughs (bear markets).
 
Peak Trough DJIA peak DJIA trough DJIA % change Coincidence
June 1899(III) December 1900 (IV) 4/4/1899 6/23/1900 -29.40% YES
September 1902(IV) August 1904 (III) 9/19/1902 11/9/1903 -37.80% YES
May 1907(II) June 1908 (II) 1/19/1906 11/15/1907 -48.50% YES
January 1910(I) January 1912 (IV) 11/19/1909 7/26/1910 -26.80% YES
January 1913(I) December 1914 (IV) 9/30/1912 12/24/1914 -43.50% YES
August 1918(III) March 1919 (I) no coincidence no coincidence no coincidence NO
January 1920(I) July 1921 (III) 11/3/1919 8/24/1921 -46.60% YES
May 1923(II) July 1924 (III) 10/14/1922 7/31/1923 -16.00% YES
October 1926(III) November 1927 (IV) no coincidence no coincidence no coincidence NO
August 1929(III) March 1933 (I) 9/12/1929 7/8/1932 -89.20% YES
May 1937(II) June 1938 (II) 3/10/1937 3/31/1938 -49.10% YES
February 1945(I) October 1945 (IV) no coincidence no coincidence no coincidence NO
November 1948(IV) October 1949 (IV) 6/15/1948 6/13/1949 -16.30% YES
July 1953(II) May 1954 (II) 1/5/1953 9/14/1953 -13.00% YES
August 1957(III) April 1958 (II) 4/6/1956 10/22/1957 -19.40% YES
April 1960(II) February 1961 (I) 8/3/1959 10/25/1960 -16.50% YES
December 1969(IV) November 1970 (IV) 12/3/1968 5/26/1970 -35.90% YES
November 1973(IV) March 1975 (I) 5/26/1972 10/4/1974 -39.80% YES
January 1980(I) July 1980 (III) no coincidence no coincidence no coincidence NO
July 1981(III) November 1982 (IV) 4/27/1981 8/12/1982 -24.10% YES
July 1990(III) March1991(I) 10/9/1989 10/11/1990 -15.30% YES
March 2001(I) November2001 (IV) 1/14/2000 10/10/2002 -35.75% YES
December 2007 (IV) no trough announced 10/9/2007 3/9/2009 -53.38% YES
For the sake of all the economists out there, we will only view stock market declines with recessions as a coincidence indicator. We cannot know when a sustained market decline is a simple correction or an indicator of a coming recession. However, in the table above, we can see that 19 out of 24 occurrences of a recession were led, or accompanied, by a decline in the stock market. The far right column indicates if there was no coincidence or an/or the percentage change of the market when there was coincidence.
 
I’m willing to submit to the view that the answer to this question is yes, stock markets lead or coincided with economic contractions. However, the nature of the recover may not meet the expectations of some, if not many, of the participants of the economy in question. During a secular bear market, the frequency and length of recessions will be longer and occur more often than during a secular bull market. The opposite is true during a secular bull market.
 
It is important to note that the designation of a recession often occurs months and sometimes year(s) after the fact. For example, the indication of the December 2007 recession was given by the NBER exactly one year later. At the same time, the coincidence of the market corresponding with or leading a recession has occurred in real time. Dow Theory gave a confirmed indication of a bear market in the month of December 2007.
 
During a secular bear market, only certain aspects of the economy will experience growth while other elements will continue to wane or hold in a range. The recession from 2007 to 2009 is just such an example. Housing and employment has not “enjoyed” the tepid growth in the economy that has occurred since the March 2009 bottom. The government has had a crowding out effect with preferential stimulus in housing and jobs, which has only prolonged the uncertainty of the “real” numbers in foreclosures and unemployment. After all, why pay your mortgage when there is a program set up to keep you in the house? Why take any old job when you could hold out for that “ideal” job because you’re getting another extension of unemployment benefits? These aren’t artificial attributes of the rising stock market and economy as some Austrian economists argue. Instead, stimulus and printing of money simply adds to the complexity within an overall secular bear market.
 
During a secular bull market, the impact of a recession will not be as deep or broad in its scope or as long as in a secular bear market. Most elements in the economy will thrive despite a build up of otherwise dire conditions (which result in severe recessions and bear markets). One industry’s fall will not impair the breadth of the economy. Corruption and scandal, in business and politics, is looked upon as isolated incidents. There is less of a demand for a complete change of the entire system when problems are revealed. Cyclical bear markets within a bull market allow for a healthy purging of excesses and reinforce the view that prior excesses were justified somehow.
 
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Richard Russell Review: Letter 762

Posted on July 20, 2010 by | Leave a comment
Letter 762 was published on August 1, 1979. At the time, the Dow Jones Industrial Average was indicated at 839.76. There were a couple of items that stood out as I read this newsletter.
Richard Russell said:
“As a matter of fact with Libya’s recent 10% cut in oil shipments and Algeria’s just announced 20% cut, I suspect that there’s an oil (and gas) glut building up now! The world is learning to cut back on fuel use—and fast, and this could turn out to be the shocker of 1979-1980.” Page 2.
In fact, it wasn’t long before oil prices reflected the glut that Richard Russell spoke of. Under normal circumstances, it would be difficult to see beyond the present crisis and think that it will end at some point. It seems that Russell was cognizant of the prospect, as remote as it seemed at the time. Unfortunately, as indicated in the chart below, $15 oil would become a base, or floor, instead of a ceiling.
One item that has been a longstanding issue with Richard Russell is reflected in the next quote.
Russell said:
“Last week I was asked this question: ‘Russell, if you could change any part of your stock approach over the past year, what would have done?’ My answer was, ‘There are many subscribers who are willing to speculate, and I think I have been too conservative and too stubborn on this issue. The change I would have made is that I would have offered speculative choices for those willing to assume the risk of buying in a market that is not over-sold and not in an ideal buying area.’” Page 2.
In addition to the previous remark by Richard Russell, he also said:

“I want to add that I personally am buying no shares here. I prefer to wait for the ‘ideal buying situation.’” Page 2.

The two remarks above have been the biggest challenge to Russell’s ability to adhere to Dow Theory or even his Primary Trend Index which was created to avoid potential market manipulation. Russell is infinitely waiting for the “ideal buying situation” while ignore individual values along the way.
Russell points out a fact that every investor should have ingrained in their mind before committing a single dollar to the stock market or any other potential investment opportunity. Russell said:
“Every investment must ultimately be valued on its return. In the stock market that means dividends. Ultimately, dividends must be paid if a stock is to be worth anything.” Page 4.
I thought that the following remark was profound.
“Now here’s an interesting aside on inflation. One of the reasons it’s so insidious is that as soon as a man starts protecting himself against it, as soon as he buys a house or a load of gold coins or a painting or a stamp collection-that man wants his inflation hedge to go up. He becomes (deep in his heart) an inflationist. Take housing: the value of total housing in this nation is $2.2 trillion (two thirds of these houses have mortgages). The last thing these home-owners want is a declining market. They are secretly in favor of rising prices and inflation.” Page 4.
Russell’s comment is right on target when it comes to the attitude of most people. It seems that everybody is an inflationist. There are few market participants or commentators who express the view that they hope their long position will decline in value. The NLO team happens to be among the few who, after going long a stock, are eagerly anticipating a decline in price. Shameless self-promotion aside, Russell’s commentary on the closet inflationists is truly profound.
Russell points out that if you’re in commodities but not in precious metal then you could be losing your shirt. Russell says:
“Commodity traders have had one of their roughest seasons in years. If you weren’t in the metals, you probably ‘got killed.’ For instance, the October cattle contract is now down from 74.45 to 61, a drop of almost 18%. One trader told me that ‘it looks like the country is vegetarian.’ Live hogs are much worse, with the October contract dropping from 51 to 32 a drop of 37%. On piggies I was told that they act like ‘the whole world is going Jewish!’” Page 5.
This counters the belief that during inflationary periods, all commodities do well or go up in value. It should be noted that the declines that were mentioned by Russell could have been the equivalent of a temporary pullback or secondary reaction. Interestingly, monthly hog prices traded in a wide range from 1972 to 2004 as indicated in the chart below. Suffice to say, anyone involved in commodity trading should be willing to accept even greater losses than the 50% that we expect for long positions in stocks before seeing any gains.
On the topic of interest rates Russell says the following:

“To the casual observer, it looked like a world embroiled in an interest rate war. And the fact is that rising inflation is being fought all over Europe and Japan- via an interest rate squeeze. The US is a frightened and reluctant follower.

“A few weeks ago Germany raised her bank rate. At the same time Britain boosted her borrowing rate a whopping 2%. Last week the US raised its discount rate an insufficient .5% to a record 10%. Canada immediately followed with a boost to 11.75% in her bank discount rate. The Japan jumped her lending fee to institutions a full 1%.” Page 5.
My thoughts on this passage are that it seems fascinating that the US wasn’t taking the lead in interest rate policy. Especially in comparison to the countries that were mention. It may have been a purposeful attempt to adjust rates when it was absolutely necessary. Could you imagine interest rates jumping 2% at a time?
Russell indicated that as the world’s leading power, the U.S. with its excessive printing of dollars cannot continue unabated. Russell said that foreign holders of dollars would become anxious and “move towards the exits.”
Russell mentions the Gold/Stock ratio; which divides the price of gold by the value of the NYSE Composite. Of the rising trend of the ratio, indicating strength in the price of gold, Russell says:

“Day after day the ratio climbs higher, and it is clear to me that shortly, SOMETHING IS GOING TO GIVE.” Page 5.

With hindsight being 20/20, my thought is that what “gives” in this situation is high inflation unless Russell was proposing that all governments are going the way of hyperinflation. My observation is that what tends to break, when two normally divergent indicators are going in the same direction, is the one that appears to be the “strongest.” In this case the stronger component of the Gold/Stock ratio was gold which had been in a multi-year rising trend while the NYSE had been in a wide trading range for an extended period of time.
I do have concerns about the sensibility of a gold/stock indicator since I have presented the view that gold and stocks usually follow each other rather than move counter to each other. For the most part, we have seen gold lag on declines and lead on rises in the stock market. One thing I’m certain of, if the price of gold rises then the stock market isn’t far behind. There may be an occasional divergence but the overall picture is that gold and stocks generally move in unison.
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Dow Theory

Posted on July 18, 2010 by | Leave a comment
The challenge of the current stock market action based on Dow Theory is the fact that we’ve had many different signals to contend with. First, lets recap the major issues that have been throwing us for a loop so far.
  • Non-confirmation of the intermediate peak of May at point B1, which failed to retest the April peak from the March 9, 2009 low.
  • Failure of the Transports and Industrials to confirm the continuation of the long-term bull trend by giving a non-confirmation at point D in mid-June.
  • Transports not confirming the declining trend by staying above the Feb. 5th low on June 6th at point C1.
The most pressing matter before us right now is the fact that the Dow Industrial decline from the April 26th peak at 11,205.03 to July 2nd at 9,686.48 (point C2). This decline equaled 1,518.55 points, half of which equals 759.28. When adding 759.28 to the July 2nd low of 9,686.48 we get 10,445.76.
On June 18th, the Industrials closed at 10,450.63 and failed to maintain the level. As alarming as the first test was (June 18th), the fact that the retest of 10,445.76 resulted in a peak of 10,366.72 on July 14th at point D2. This demonstrates a large amount of weakness, and resistance, at the halfway point of a large intermediate decline. If the market cannot definitively breach the 10,445.76 level then my bias on the market is bearish. We will be in a bear market, from a Dow Theory standpoint, when, and if, the Industrials and the Transports go below their respective February 5th lows.

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Dow Theory and Richard Russell

Posted on July 11, 2010 by | Comments Off on Dow Theory and Richard Russell

In attempting to understand Dow Theory it is necessary to follow the best and the brightest on this topic. Over the last 52 years, the brightest person on Dow Theory has been Richard Russell. No single person has been more outspoken on their views on the market using Dow Theory, uninterrupted since 1958, than Richard Russell. So when Richard Russell does an about face on his interpretation of Dow Theory it is worth our time to examine the reasons.

First, it is necessary to provide context around the ideas on Russell’s most recent market call.

  • From November 12, 2007 to January 2, 2009, Russell indicated that we were in a bear market. The Dow went from 12,987.55 to 9,034.69, a decline of -30.44%.
  • From January 5, 2009 to January 12, 2009, Russell indicated that we were in a bull market. The Dow went from 8,952.89 to 6,926.49, a decline of –22.63%.
  • From March 11, 2009 to July 22, 2009, Russell indicated that we were in a bear market. The Dow went from 6,930.40 to 8,881.26, a gain of +28.15%.
  • From July 23, 2009 to May 19, 2010, Russell indicated that we were in a bull market. The Dow went from 9,069.29 to 10,444.37, a gain of +15.16%.
  • From May 20, 2010 to July 8, 2010, Russell indicated that we were in a bear market. The Dow went from 10,068.01 to 10,138.99, a slight gain was registered for the period (<1%).

On July 9, 2010, Richard Russell said:

“When the facts change, I change. To do otherwise would be idiotic. Something occurred yesterday that made me sit up and take notice. We had the non-confirmation by the D-J Transportation Average, a situation that I discussed on the July 5 site.”

“Following the Transport non-confirmation, yesterday the market surged higher, Dow up 274 and Transports up 152. But that’s not all. What I noticed was that yesterday was a 90% up day [up volume versus down volume] — the formula for a bottom.”

According to Russell, the Transports non-confirmation along with a 90% up volume/down volume ratio is what led to the conclusion that the market was indicating that a bottom was in. Russell goes on to recommend buying various ETFs with stop losses. Several problems arise when market action is viewed from Russell’s perspective.

First, Russell has ignored the fact that a trend is in place until a counter trend is signaled. So far, we haven’t had a bear market indication since the March 9, 2009 low. If the Transports were to confirm the Industrials by falling below the February 5, 2010 low, then we’d have our first bear market signal.

Second, when thinking in terms of Dow Theory, market participants have three variables to consider the Dow Jones Transportation index, Dow Jones Industrials and NYSE volume. Volume attributes are considered over a period of time. Single day action on volume should not be the determining factor for considering a bull or bear market. If this is the case, then most market signals could be very misleading. In my observations, market volume has increasingly become an addendum to Dow Theory.

Third, Russell has often disregarded the pure Dow Theory indications that have come along the way since the March 2009 low. It seems that Russell’s understanding of macro issues and his personal experience in the markets has led to his decision to err on the side of caution. However, Russell’s cautious streak has usurped the value of Dow Theory to act as a “…composite index of all the hopes, disappointments, and knowledge of everyone who knows anything of financial matters, and for that reason the effects of coming events (excluding acts of God) are always properly discounted in their movement. The averages quickly appraise such calamities as fires and earthquakes.” (Rhea, Robert, The Dow Theory, page 19).

Next, Russell has set himself up for the need to change his analysis by not thinking through Dow Theory to its conclusion. By calling a bottom at this juncture, Russell has left out the all-important confirmation that is required by the Industrials and Transports. 10,450.64 and 4,467.25 are the new levels that the Industrials and Transports need to surpass before any buying policy should be considered. In addition, after surpassing the referenced upside confirmation points, the next level of resistance is 8% away for both indexes. This means that we could go to the old high and then quickly reverse to the downside if a bull market confirmation isn’t signaled. However, given the most recent market action, our focus should be on the confirmation of the reversal pattern first, then the possible bull market indication.

Another matter of concern is that Richard Russell makes recommendations that don’t address the issue of investing in values. Values are a core tenet of Dow Theory. In fact, when you read Dow Theory Unplugged or Charles H. Dow: Economist, you will find that values, not technicals, are espoused. Russell points his readers to speculative opportunities instead of undervalued stocks which can be held for “the long term” if the bullish assessment happens to be incorrect. Our list of Dividend Achiever stocks at or near a new low addresses the prospect that if we’re wrong there is some recourse. In this case, you get the ability to compound your investment over time with the prospect of capital appreciation.

Finally, our stance on stop loss orders is widely known as indicated in the article “Automatic Orders Don’t Provide Protection” as well as our disclaimer at the end of each sell recommendation. Russell’s recommendation of buying ETFs is reckless at best especially in light of the May 6, 2010 “flash crash.” Adding fuel to the flames is the article titled “ETF ‘Circuit Breakers’ Needed to Stop Flash Crashes: Pros.” Our stance on ETFs is well founded and preceded any discussion of the true risks associated with them on May 6th (“ETF: Mediocrity With No Pretense of Value” and “ETF: Indiscriminant Risk”).

It is likely that perma-bulls will seize on the Russell commentary of July 9th as the heralding of a new-new era in investing. On the other hand, “contrarian investors” will suggest that when Richard Russell, perma-bear that he is, has entered the bull ring then the bull run is definitely over. It is our contention that while Richard Russell might be right about a reversal pattern being in place he is not using Dow Theory.

Our latest views on Dow Theory can be found at the following link (NLO on Dow Theory). Keep in mind that all trends are considered to remain in place until otherwise indicated. So far we are still in a cyclical bull market within a secular bear market

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Dow Theory and Richard Russell

Posted on July 11, 2010 by | Leave a comment
In attempting to understand Dow Theory it is necessary to follow the best and the brightest on this topic. Over the last 52 years, the brightest person on Dow Theory has been Richard Russell. No single person has been more outspoken on their views on the market using Dow Theory, uninterrupted since 1958, than Richard Russell. So when Richard Russell does an about face on his interpretation of Dow Theory it is worth our time to examine the reasons.
First, it is necessary to provide context around the ideas on Russell’s most recent market call.
  • From November 12, 2007 to January 2, 2009, Russell indicated that we were in a bear market. The Dow went from 12,987.55 to 9,034.69, a decline of -30.44%.
  • From January 5, 2009 to January 12, 2009, Russell indicated that we were in a bull market. The Dow went from 8,952.89 to 6,926.49, a decline of –22.63%.
  • From March 11, 2009 to July 22, 2009, Russell indicated that we were in a bear market. The Dow went from 6,930.40 to 8,881.26, a gain of +28.15%.
  • From July 23, 2009 to May 19, 2010, Russell indicated that we were in a bull market. The Dow went from 9,069.29 to 10,444.37, a gain of +15.16%.
  • From May 20, 2010 to July 8, 2010, Russell indicated that we were in a bear market. The Dow went from 10,068.01 to 10,138.99, a slight gain was registered for the period (<1%).
On July 9, 2010, Richard Russell said:

 

“When the facts change, I change. To do otherwise would be idiotic. Something occurred yesterday that made me sit up and take notice. We had the non-confirmation by the D-J Transportation Average, a situation that I discussed on the July 5 site.”
“Following the Transport non-confirmation, yesterday the market surged higher, Dow up 274 and Transports up 152. But that's not all. What I noticed was that yesterday was a 90% up day [up volume versus down volume] -- the formula for a bottom.”
According to Russell, the Transports non-confirmation along with a 90% up volume/down volume ratio is what led to the conclusion that the market was indicating that a bottom was in. Russell goes on to recommend buying various ETFs with stop losses. Several problems arise when market action is viewed from Russell’s perspective.
First, Russell has ignored the fact that a trend is in place until a counter trend is signaled. So far, we haven’t had a bear market indication since the March 9, 2009 low. If the Transports were to confirm the Industrials by falling below the February 5, 2010 low, then we’d have our first bear market signal.
Second, when thinking in terms of Dow Theory, market participants have three variables to consider the Dow Jones Transportation index, Dow Jones Industrials and NYSE volume. Volume attributes are considered over a period of time. Single day action on volume should not be the determining factor for considering a bull or bear market. If this is the case, then most market signals could be very misleading. In my observations, market volume has increasingly become an addendum to Dow Theory.
Third, Russell has often disregarded the pure Dow Theory indications that have come along the way since the March 2009 low. It seems that Russell’s understanding of macro issues and his personal experience in the markets has led to his decision to err on the side of caution. However, Russell’s cautious streak has usurped the value of Dow Theory to act as a “…composite index of all the hopes, disappointments, and knowledge of everyone who knows anything of financial matters, and for that reason the effects of coming events (excluding acts of God) are always properly discounted in their movement. The averages quickly appraise such calamities as fires and earthquakes.” (Rhea, Robert, The Dow Theory, page 19).
Next, Russell has set himself up for the need to change his analysis by not thinking through Dow Theory to its conclusion. By calling a bottom at this juncture, Russell has left out the all-important confirmation that is required by the Industrials and Transports. 10,450.64 and 4,467.25 are the new levels that the Industrials and Transports need to surpass before any buying policy should be considered. In addition, after surpassing the referenced upside confirmation points, the next level of resistance is 8% away for both indexes. This means that we could go to the old high and then quickly reverse to the downside if a bull market confirmation isn’t signaled. However, given the most recent market action, our focus should be on the confirmation of the reversal pattern first, then the possible bull market indication.
Another matter of concern is that Richard Russell makes recommendations that don’t address the issue of investing in values. Values are a core tenet of Dow Theory. In fact, when you read Dow Theory Unplugged or Charles H. Dow: Economist, you will find that values, not technicals, are espoused. Russell points his readers to speculative opportunities instead of undervalued stocks which can be held for “the long term” if the bullish assessment happens to be incorrect. Our list of Dividend Achiever stocks at or near a new low addresses the prospect that if we’re wrong there is some recourse. In this case, you get the ability to compound your investment over time with the prospect of capital appreciation.
Finally, our stance on stop loss orders is widely known as indicated in the article “Automatic Orders Don’t Provide Protection” as well as our disclaimer at the end of each sell recommendation. Russell's recommendation of buying ETFs is reckless at best especially in light of the May 6, 2010 “flash crash.” Adding fuel to the flames is the article titled “ETF ‘Circuit Breakers’ Needed to Stop Flash Crashes: Pros.” Our stance on ETFs is well founded and preceded any discussion of the true risks associated with them on May 6th (“ETF: Mediocrity With No Pretense of Value” and “ETF: Indiscriminant Risk”).
It is likely that perma-bulls will seize on the Russell commentary of July 9th as the heralding of a new-new era in investing. On the other hand, “contrarian investors” will suggest that when Richard Russell, perma-bear that he is, has entered the bull ring then the bull run is definitely over. It is our contention that while Richard Russell might be right about a reversal pattern being in place he is not using Dow Theory.
Our latest views on Dow Theory can be found at the following link (NLO on Dow Theory). Keep in mind that all trends are considered to remain in place until otherwise indicated. So far we are still in a cyclical bull market within a secular bear market.

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Richard Russell Review: Letter 742

Posted on July 6, 2010 by | Leave a comment
Dow Theory Letters issue 742 was published on November 1, 1978. At the time, the Dow Jones Industrial Average indicated was at the 806.05 level. In this issue, Richard Russell discusses several topics that are very important to every Dow Theorist.
First, Russell states that:
“…history shows that when bull (or bear) markets really begin, Dow Theory signals are generally greeted with derision, skepticism, and scorn-rather than wholesale agreement!” page 1
This comment is in response to the Dow Theory bull market signal that was given on August 2, 1978. In this case, Russell felt there wasn’t enough skepticism by market participants to warrant a need to trust the signal. I’m guessing that after 12 years of a secular bear market any good news about the market would appeal to the glass half-full crowd.
Letter 742 also has a chart (located here) of the Dow Jones Industrials, Transports, Utility Averages and NYSE volume. Upon closer inspection of the chart below, ranging from March 28, 1978 to October 27, 1978, you can find two confirmations of a bull market and one confirmed bear market indication as part of Dow Theory.

According to Russell, point A (August 2nd), on the Dow Industrials, was a false secondary peak or bull market indication. However, it should be noted that when the Industrials went above the June 29th peak of 821.64 (point A1) on July 21st it was a clear indication that the index was going to retest the previous high at point A.

After the bull market move upward a bear market indication was given when the Industrials and Transports fell below point B1 that corresponded to the August 31st low of 876.82 and 248.78 respectively. A bull market non-confirmation was indicated (red circles) in the fact that neither index could exceed the high of September 8, 1978.
Let’s do the math for a moment, point A1 gave a buy signal plus point A’s confirmation of the buy signal equaled a 9.62% rise by the time the market gave the bull market non-confirmation at Dow Industrials 900. The same timing applied to the Dow Transports would have equaled a gain of 13.64%. To my mind, this was in line with our view that any return close to 10% in less than a year is an acceptable amount to trigger a sell of any stock.
Russell also repeats a common attribute that he seeks in the market before considering going “all in.” Russell says:

“I noted that every bull market in history had started from an over-sold base, but that this market had not seen a over-sold condition since late-1976.” Page 1.

In this remark, I have two thoughts that immediately come to mind which is reflected in the chart below. The first is that even after the 1974 bottom there was another time (1976) that was “most ideal” to buy stocks at over-sold levels, according to Russell. However, even though late-1976 was experiencing oversold conditions, it certainly didn’t mean that further declines were out of the question. After the ’76 bottom, the Dow Industrials had a short rally and then fell as low as 742.12, a decline of 19.69% from the 1976 lows, by February 28, 1978. Finally, the view that an over-sold base is a condition necessary for a bull market may not be accurate.

On page 2 Russell said:

“Right now, I want all my subscribers to stay out as per my instructions in Letter after Letter.”

This suggests that after the January 1975 buy signal given by Russell, it was very difficult to keep a long-term position even though it was the absolute best time to “buy and hold” stocks.

“The violence and rapidity of this smash has few precedents in stock market history.” Page 2.

When calculated to the November 14, 1978 low, the decline from September 8, 1978 equaled a drop of 13.5%. To me this doesn’t seem like all the much of a decline.

“Somewhere in the period ahead, we are going to see the real ‘third phase bear market action’ in the Dow and most other stocks. True, during 1973-1974 the majority of stocks were pulverized in a slide that was comparable to 1929-32 in many ways. But the Dow lost less than 50% of its value at that time. My guess is that before the third or final phase of this bear market is over, we are going to see the Dow at drastic new lows, we’re going to see dividends cut across the board, we’re going to see very high interest rates, and we’re going to see something that this generation has never seen before-wholesale liquidation of debt in all sections of the economy, private, corporate and perhaps even government.” Page 2

“Each time it looks as if the ‘plug is going to be pulled,’ the bear market (with the help of huge infusions of monetary inflation from the Fed) pulls itself out of the hole.” Page 2

Russell was waiting for the third phase of the bear market. According to Russell, the Fed was holding the market up with the trade-off being higher inflation. My thinking is that a crash didn’t occur simply because the Fed was willing to accept higher inflation as a substitute for a crash. In addition, if the markets were to get a crash and record inflation at the same time it would be exceptional situation. The third phase decline that Russell expected never seemed to materialize on the scale of 1973-74 or greater.
Other Notes in Letter 742:
  • E. George Schaefer’s investment performance from 1949 to 1966.
  • James Dines book the “Invisible Crash”
  • MC Horsey’s chart of an inflation adjusted Dow since 1960
  • Benjamin and Herbert Stein’s book “On the Brink” with reference to, of all things, the Chinese cornering the gold market
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Richard Russell Review: Letter 745

Posted on July 4, 2010 by | 1 comment
Dow Theory Letters Issue 745 was written on December 6, 1978.  At the time, the Dow Jones Industrial Average was indicated to be at the 811.42 level.  What stood out the most to me was the fact that Richard Russell made very clear commentary on the price of gold and the direction of stocks.  Russell made the following commentary:

"It [gold/stock ratio] is telling us that for the foreseeable future (until the next signal), if we do anything we should do it in stocks." page 3.

Anyone familiar with the stock market in 1978 would know that if you had bought a handful of stocks and didn't sell them until 10 years later you would have had a compounded annual growth rate of 8.73% (this takes into consideration the crash of 1987).  Russell's comments on being in stocks would have seemed to be very much on target.  However, it is his aversion to gold at this time that seems to contradict his earlier comments on gold.
In Letter 742 dated November 1, 1978, Richard Russell said the following about gold:
"Slowly, very slowly, it's dawning on the world that we're witnessing one hell of a bull market-in gold. I've been writing pages and pages about gold in each Letter, trying to get new subscribers in the metal (or the coins), trying to get older subscribers to STAY in gold.  Happily, a large percentage of my subscribers are now sitting with large gold positions.  And the paper profits (in terms of dollars) are mounting." page 5.

This commentary seems odd because in Letter 745, Russell goes on to say:

"At any rate, it is a bearish omen when the [gold] open interest stays high in the face of a persistent decline, and that is what has occurred." page 6

Russell called himself to task by asking the following question:

"Question: Russell, you were so hot on gold a few months ago.  Gold was 'real money,' you said.  Gold 'would save the system,' you said.  How can you just "turn off" on gold?
"Answer: I haven't turned off on gold, I've turned off on gold at this time.  The market isn't like your wife or your daughter who you love through thick and thin.  We're dealing here with correct procedure and purchasing power.  The fact that I advocate gold-backed currency has nothing to do with the fact that I think gold is in a bear trend over the coming months.  In this business, you had better learn that the trend makes you the money, not the item.  I'd rather buy Cesspools, Inc. if that stock was going up than IBM if IBM is heading down." Page 7
In retrospect, we know that gold went as high as $850 an ounce in January 1980.  However, it is interesting to me that Russell said that a bear trend was approaching "...over the coming months."  In Letter 745, Russell included a chart that compared the London Gold to the Gold Stock Average.

 

Russell's favorable comments of gold on November 1, 1978 were well off of the highs from the prior month.  However, since Russell was a practioner of Dow Theory and was using the London price of gold along with the equivalent of the XAU gold index to act as a confirming mechanism for the future price of gold, it should have been considered that because the London price didn't fall to the corresponding low set in April of 1978 that there must have been a non-confirmation of the downside trend.  Instead, Russell said the following:
"The GSA [Gold Stock Average] has collapsed, and is now down to its previous low for the year recorded last April.  Bullion has obviously held up better than the gold shares, but so far the downside non-confirmations by bullion have failed to halt the decline.  This kind of action is always indicative of a weak market, and it just seems that there are still too many optimistic gold-holders around." Page 6.
Is it possible that the gold shares are held by the public and speculators (weak hands) and the bullion is held by investors and "institutions" (strong hands)?    Somehow I think this relationship has some value.  I'm just not sure if Russell called this intermediate move correctly.  So I decided to search for an updated version of the London Gold and GSA comparison.  Below is what I found in the July 5, 1979 issue:

 

It should be noted that the exact bottom in the price of gold and gold stocks (red circles) coincided with the publishing of the December 6, 1978 Letter 745.
Also Worth Mentioning:
  • Russell said that "Greed and options don't mix."  My impression on this remark is that I always thought that the purpose of options is to get exaggerated gains with the trade-off being no equity.  Seems to me that greed and options go hand in hand.
  • Dow Theory Letters are available at http://www.dowtheoryletters.com/
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Dow Theory

Posted on June 29, 2010 by | Leave a comment
The markets are getting very close to giving us the Dow Theory indication that we need to exit a majority of our positions. Today (June 29, 2010), the Dow Jones Industrial Average closed at 9870.29 which is 53.80 points above the June 7, 2010 of 9816.49. Falling below 9816.49 would be one half of the bear market signal needed to indicate that the market will fall precipitously.

To make matters worse, the Dow Jones Transportation Index closed down today nearly twice as much as the Industrial Index. This indicates that there is significant selling interest. This doesn’t bode well for the Transports because in order to trigger the second half of the bear market signal the index would only have to fall 248.61 points. After today’s decline of 169.52 points in a single day, the remaining 79.09 points needed would not be all that difficult to come by.
The chart below displays a critical reason why I would be bearish on the market at this time. The dashed black line extending from B1 was supposed to be the upside target from point C1 in our last Dow Theory article. However, neither the Industrials nor the Transports were able to come close enough to be misinterpreted as an indication that the bull market run was likely to continue. The inability of the market to breach point B1 was a major non-confirmation according to Dow Theory.
Finally, any simultaneous declines of the Industrials and Transports below the yellow zones on a closing basis would tell us for certain that the bull market has run its course and that an additional correction of 15% on the Dow Jones Industrial Average is likely.

We’re being generous by not considering the June 7th lows for both indexes as the critical points for a bear market indication. For some Dow Theorists, waiting for the Transports low on February 5th is akin to playing with fire. However, we must adhere to the extremes to ensure quality buy and sell signals.

The only holdout is that either the Transportation Index or the Industrial Index gives us a downside non-confirmation by not going below the Feb. 5th or the June 7th lows, respectively. If we get a downside non-confirmation then we will consider selling a small portion of the portfolio on any strength.

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Dow Theory

Posted on May 13, 2010 by | Leave a comment
The decline from the intermediate high on May 12, 2010 is now putting in place the prospects for another classic secondary reaction of the Dow Industrials. According to Dow Theory, secondary reactions can range from 33% to 66% of the move upward from the previous low in the last secondary reaction.

In the chart below, you can see that the last secondary low took place at point C on February 5, 2010.

Depending on the point you choose (using the closing price or the intraday low), the Dow reached a low at 9822.83 on February 5th. From the low, the peak in the Dow occurred on April 26th at the intraday high of 11,308.95. Based on the difference of the low and the high, the next potential downside targets are as follows:
  • 10,565.89
  • 10,318.21
  • 9822.83
According to Charles H. Dow, analysis of market action needs to take in any periods that have similar characteristics. In this case, I believe that the Dow is tracing out exactly the same pattern as had happened from January 19th to February 5th. In the points A1, B1, and C1 we can see the pattern that might materialize according to Dow’s theory.
So far, we have already traced out the pattern from A1 to B1. The turn at B1 has laid the groundwork for what we can expect might happen next. The prospect is that we fall below 10,375 and possibly turn upward somewhere around 10,200. However, because of the extreme decline that occurred on May 6th, the Dow could fall as low as point C and still reverse back to the point B1.
If the Dow falls below the blue line at point C, then we can label the market trend as bearish. In addition, all of the moves in the Dow Industrials must be confirmed by the Transportation index. The ideal scenario is that the index goes back to B1 at the very least. However, with all the recent turmoil in the markets, I would not be surprised if we got a bear market signal below point Z.
It should be noted that although I have only discussed a bunch of lines going up and down, the ideas behind the concepts are rooted in fundamentals. The very same fundamentals that formed the basis for investors like Graham, Dodd and Buffett.

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Dow Theory Q & A

Posted on April 13, 2010 by | Leave a comment
Reader SD asks:
 
"If the Dow appears to hit a peak and begins dropping (Dow Theory bear market indication), is the indicated action to sell your stocks and put your investments into cash until the Coppock curve or other indicators show the market has hit a bottom?"
 
Touc's Reply:
 
There are several approaches to the use of Dow Theory when determining the best time to sell stocks. The first could be to sell all stocks when a Dow Theory bear market is signaled. The second could be to ignore the gyrations of the market and only sell a stock when it is "clearly" overvalued. The final method is the one that I use which involves changing my allocation of stocks.
 
In the first scenario, we will take the perspective of the great Dow Theorists Richard Russell on the application of Dow Theory towards the portfolio when a bear market is signaled. Upon reflection of the market declines from October 2007 to March 2009, Richard Russell said, "...Let's say you are compounding your assets (reinvesting your dividends and interest) beautifully until a full-fledged primary bear market comes along (1973-74 and again in 2008). Within a year or two your assets are cut in half, and all your compounding has gone to waste." By this commentary, Russell seems to imply that an investor should sell all of their stocks at the onset of a Dow Theory bear market indication or risk wiping out tremendous gains that might have been accrued in the process.
 
On November 12, 2007 Richard Russell call the bear market top in the weekly financial publication Barron's. According to Russell, it makes no sense to trifle with the bear market which can plumb depths unimaginable in a period of time that is far shorter than it takes to rise in a bull market. So why risk wasting the power of compounding to a bear market, especially when you "know" it is coming. In this respect, Russell says sell all of your stocks and wait until the next bull market indication to arrive.
 
The second Dow Theory approach to selling a stock is the most commonly misapplied. This approach is supposed to be grounded on the belief that market participants understand values. The misapplication that often occurs is when overvaluation is ignored and a stock isn't sold based on this fact. All Dow Theorists can point to the buying and selling of stocks as being based in the understanding of values. The claim of an understanding of values applies to stocks that are undervalued as well as overvalued. An undervalued stock should be bought while an overvalued stock should be sold, regardless of market condition. Once an undervalued stock has been purchased it could take weeks, months, or years before the stock is overvalued. A stock that has become overvalued should be sold at the earliest opportunity and is often at a new high.
 
In answer to the question of when to sell a stock based on values, the renowned Dow Theorist Robert Rhea had the following to say:
 

"Investors may ask how they can determine the point when stocks are selling far above value and probable earnings. That, indeed, is a hard question to answer because no two men appraise values on the same basis. I can only say that sometime before the peak was reached in 1929, American Telephone and Telegraph [AT&T] (T) was selling around $300 per share. It had a book value of about $128, and its best recorded earnings were in 1929 when the reported net for common was $12.67 per share. Now in 1926 the stock had sold for $151 when its book value was $126, with earnings of $11.95. With its dividend at $9.00, a comparatively small amount was carried to surplus each year. At the price first noted above, the advance in the quoted value of this stock had obviously discounted earnings for many years in the future; moreover, it was selling far above its intrinsic value."

The last method for buying and selling is one that I have combined and modified based on the methods described above which involves taking the Dow Theory signal and allocating more or less money to a given stock. During periods when there is a Dow Theory bull market indication, I invest a minimum of 25% of my capital in a single stock that is at or near a new low. After obtaining what I believe to be "fair profits," I rotate the money into the next "undervalued" Dividend Achiever or Nasdaq 100 stocks. As long as the bull market indication is in effect, I continue to overweight my stock positions in solid companies with proven track records. I'm very flexible in the amount of time that it takes to accomplish the goal of exceeding "guaranteed" money alternatives like treasuries, CDs, money market and savings accounts on an annualized basis.
 
As soon as a bear market signal is given, based on Dow Theory, I shorten the amount of time that I'm willing to wait for an undervalued stock to generate "fair profits." In addition, I cut my minimum position in an individual stock down from 25% to 12% (generally speaking). Basically, I reduce the amount of risk that I'm willing to take in a stock under conditions that might not be as favorable for gains. However, I do not sell stocks outright in anticipation of market declines based on Dow Theory bear market indications. Keep in mind that, under certain circumstances, a bull market can still be in effect after a decline of 20% to 30%. This leaves a lot of room for miscalculation if you automatically sell based on a decline of 10% or more.A review of my 2008 and 2009 transaction histories should demonstrate the value of the approach described above. Follow-up commentary regarding the 2008 transaction history is worth reading as it provides additional insight to the methods now used by the New Low Observer team. It is important to note that, although there was a bear market indication since November 2007, activity in the market did not cease.
 
Again, keep in mind that bear markets are no guarantee of losses in your portfolio. Charles H. Dow, founder of the Wall Street Journal, has said that:
 

"Even in a bear market, this method of trading will usually be found safe, although the profits taken should be less because of the liability of weak spots breaking out and checking the general rise."

I feel that the strategy that we employ is very close to what Charles H. Dow had written about in regards to buying and selling stocks in both bull and bear markets.
 
Art's Reply:
 
Even when a bull market indication is given or the Coppock Curve turned positive, we have to be rational about deploying our capital. A Dow Theory buy indication doesn't signal "all-in" or imply that we can buy stocks blindly. Some stocks performed wonderfully and some lag the market. The same can be said about bear markets.
 
Touc and I bought Altria (MO) in early December 2008 when the company yielded 8%. This transaction occurred during the bear market and took place months before the market reached a bottom. Our sell recommendation netted 13% in less than 2 months.
 
If you'd like to prepare yourself for the coming bear market, I suggest that you pick up a book by Harry Schultz, Bear Market Investing Strategies.
 
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Dow Theory

Posted on April 11, 2010 by | 2 comments
On Friday April 9, 2010, the Dow Jones Industrials and the Dow Jones Transportation Averages both moved to new highs at the same time. According to Dow Theory, this confirmation by both averages would indicate that the market has more room to go on the upside before a change of direction is to take place.
The path to this bull market confirmation (within a secular bear market) has been a battle with many casualties. The last week had many examples to demonstrate this point. On April 5th, the Industrials broke to a new closing high however the Transports did not confirm. On April 6th, the Transports broke to a new high but the Industrials did not confirm. On April 8th, the Transports broke above the high that was established on April 6th however the Industrials could not exceed the previous high of 10,973.55 set on April 5th.  April 9th finally cleared the air on the much needed confirmation of the market's trend.
The factors that are in favor of the continuation of the bull market are that the Industrials and Transports are 50% above their respective 2007 to 2009 declines. Additionally, prior declines within secular bear markets like 1906 to 1924 or 1966 to 1982 have had many retrenchments of 80% to 100% before falling back to the old lows. So far, the Industrials have recouped 58.42% of the previous decline. If the Industrials were to retrace a classic Dow Theory 2/3 of the previous decline, the index could go to 11,574.59 with no problem.
However, the tepid nature of the gains that led to the new highs along with the lackluster volume that has accompanied the move up from the March 9, 2009 low doesn’t seem to encourage confidence in the direction. More alarming is the fact that we are not near historical levels of under-valuation in the market in general. The Dow Industrials currently has a dividend yield of 2.48% when the long-term average high yield is around 6%. Also of concern is that the Dow Fair Value is at 6.92 times the dividend yield. This is contrasted with the 1.52x that is normally associated with great buying opportunities.
The former editor of the Wall Street Journal and Dow Theorist William Peter Hamilton once said, “the wish must never be allowed to father the thought.” For this reason, we will take a wait and see approach to the market going forward.  However, until proven otherwise, we are on a march back to Dow 14,164.53, which was set on October 9, 2007. In anticipation of the rise to the old market high, we have illustrated, in the chart below, three upside scenarios for the Dow Industrials.
The first projection (green line) assumes that the Industrials will continue the torrid pace set from March 9, 2009 to January 19, 2010. The likelihood of the index continuing at such a pace is not expected. However, in the book Charles H. Dow: Economist by George W. Bishop, Jr., it is noted that, according to Charles Dow, there are two stages to a bull market in stocks and that the second stage is more bullish than the first stage. This contrasts sharply with Robert Rhea and William Peter Hamilton’s assertion that there are three stages to every bull and bear market. If we are in the transition to the “second and final” stage of this bull run then it is possible for the market to continue on, and possibly exceed, the first trajectory that was previously set. The projected date that the Dow would reach 14,164.53 is November 19, 2010.
The second projection (blue line) is based on the March 9, 2009 to April 9, 2010 action on the Dow Jones Industrials. This pace seems more realistic than the first projection since it assumes a less dramatic increase in the index. To think that the market could continue moving higher as it had in the past would be quite unrealistic. Based on the current trajectory the Dow would reach the old high by January 31, 2011.
Finally, the third projection (black line) is based on the current trend being the mean and the first projection being the high end of the range. The third projection is a mirror of the first. The third trajectory would reach the old high by June 18, 2011.
Although we have a clear bull market confirmation (within the context of a secular bear market) it is necessary to determine where the downside targets should be. According to Dow’s Theory the following are the targets for a subsequent decline:
  • 9513.92
  • 8030.49

In addition to the normal downside targets, there is the prospect that if the Dow falls below the imaginary third projection level (black line), then all bets are off.  From the current Dow Theory confirmation, if the index cannot retains the level of 10,997.53 beyond July 15, 2010, then the market should have a major correction shortly thereafter.
Reaching the old high is all within the context of a normal secular bear market. The tendency is for the market to get to the old high and then quickly wipe out the notion that a new secular bull market is about to begin. This is the nature of a secular bear market.
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Dow Theory

Posted on March 23, 2010 by | Leave a comment
On October 16, 2009, I wrote an article on SeekingAlpha.com titled “Stock Market Projections,” where I attempted to predict the next low point for the Dow Industrials. In that article I said:
“After I ran the numbers, the cycle analysis method indicates that from January 24, 2010 to February 15, 2010 is the next expected low.”
Eerily, the Dow Jones Industrial Average has managed to hit a major low on February 8, 2010. This is almost exactly in the middle of the range where, based on cycle analysis, the Industrials were expected to go. At the time it was my assertion that after hitting the low in February 2010 we could expect that the next move upwards would be to the 12,000 level.
The case for the move upward has been bolstered by the fact that, according to Dow Theory, the Industrials and the Transports have exceeded their January 2010 highs based on the closing price of March 18, 2010. However, as the Industrials have exceeded their March 18th closing price the Transports have not followed through so far.  This type of divergence between the two indexes is generally considered to be a non-confirmation.
The great Dow Theorist Richard Russell (Dow Theory Letters) has spoken at length about non-confirmations in the indexes and how to interpret the trend of the market in this context. According to Russell:
"It is a reasonable practice in areas of non-confirmation or divergence to give precedence to the primary direction. Thus, after a rally in a bear market, when one Average refuses to confirm the other on the upside, the strong presumption is that the next direction of the market will be down. More positive proof is provided if the two Averages then retreat below previous minor decline lows. The converse of this is true in a bull market, and many impressive advances have been “tipped-off” in areas where one Average refused to follow (confirm) the other through an important low point."
Richard Russell, Dow Theory Letters, Issue 102, May 2, 1960, page 2. www.dowtheoryletters.com
We would not be totally satisfied with the bull market indication (within a secular bear market) until the Transportation Index is able to go above 4422.50. However, until that time, we would consider this a bull market that is waiting for a confirmation rather than a potential bear market in the making. While we’re still sticking to a projected Dow Industrials of 12,000, the market has seemed to run out of the explosive bursts on the upside that it once had. Despite this concern, we wouldn’t be surprised of the market truly melted up from the current level.
  • The article on Seeking Alpha titled “Stock Market Projections” is here.
  • For better viewing, the chart in the article is here. 

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Dow Theory Q & A

Posted on February 23, 2010 by | Comments Off on Dow Theory Q & A
A reader writes:
 
"Without the Obama stimulus and intervention from the FED it would already be below 5000. The existing position is totally artificial, unsustainable and downright ephemeral. Any one that claims that this synthetic bull market is sustainable is full of it.
 
"It is interesting to note how much you can derive from the historical shape of a line with zero analysis of why it was that shape. You have not even quoted a single example of a similar pattern resulting in a similar outcome to your predictions. In other words, this is not a scientific approach. It not even a logical approach. I can only conclude that the sole purpose of such analysis is to influence the market in a desired direction. In other words it is a propaganda approach."
 
Our Response:
 
Manipulation is a factor of the market in the day-to-day movement. However, the long-term trend of the market cannot be manipulated as demonstrated from the writings of William Peter Hamilton, former editor of the Wall Street Journal.
 
Using Dow Theory, Hamilton called the top in the stock market on October 25, 1929 in a WSJ editorial titled “A Turn in the Tide.” It should be noted that the comments on manipulation made by William Peter Hamilton were done when it was well known who and when manipulation took place prior to the institution of the SEC.
 
In his book The Stock Market Barometer, Hamilton outlines many methods of manipulations as they took place and its relevance to the overall market. In his book, Hamilton says of manipulation:
 
  • “The market is always under more or less manipulation.” page 37.
  • “Even with manipulation, embracing not one but several leading stocks, the market is saying the same thing, and is bigger than the manipulation” page 42.
  • “Major Movements Are Unmanipulated-One of the greatest of misconceptions, that which has militated most against the usefulness of the stock market barometer, is the belief that manipulation can falsify stock market movements otherwise authoritative and instructive” page 49.
  • “These discussions [of manipulation] have been made in vain if they have failed to show that all the primary bull markets and every primary bear market have been vindicated, in the course of their development and before their close, by the facts of general business, however much over speculation or over-liquidation may have tended to excess, as they always do, in the last stage of the primary swing” page 50.
  • “It has been shown that, for all practical purposes, manipulation has, and can have, no real effect in the main or primary movement of the stock market, as reflected in the averages. In a primary bull or bear market the actuating forces are above and beyond manipulation. But in the other movements of Dow's theory, a secondary reaction in a bull market or the corresponding secondary rally in a bear market, or in the third movement (the daily fluctuation) which goes on all the time, there is room for manipulation, but only in individual stocks, or in small groups, with a well-recognized leading issue” page 73.
Hamilton, William Peter, The Stock Market Barometer, Wiley & Sons, New York, 1922.
Another great Dow Theorist, Richard Russell, editor of the Dow Theory Letter which has been published consistently since 1958, called the market bottom in October 1974 and called the top in November 2007 (read Barron's article here). The extensive history of reasonably accurate and well-documented calls of market direction make examining Dow Theory worthwhile. The purpose of showing Russell’s remarks on the topic of manipulation is to demonstrate that, although there is a distinct difference between the pre-1934 SEC market of Hamilton era and today, the rules, according to Dow Theory, remain the same.
 
In The Dow Theory Letters, Richard Russell reiterates the fact that:
 
“One of the most difficult concepts to get across to subscribers is the concept of primary trend of the market. This may be old hat to my veteran subscribers of 10 or 20 years, but the whole idea of the primary trend bears repeating now.
 
“There are three trends in the market, all working with each other simultaneously. There is the great primary trend, lasting usually a few years up to 15 years or even longer. There is the secondary trend lasting usually a few months up to a year. And there is the minor or daily trend lasting a few days to a few weeks or so.
 
“The minor trend of the market is open to manipulation. This shortest of trends may reflect a news event, a sudden scare, a sunny word from the president or any of a thousand other possibilities.
 
“The secondary trend often reflects a short-lived expansion or recession that the economy or some very major news event. The secondary trend is also open to manipulation, usually on the part of the Fed in that the Fed can make money tight or loose (the Fed can even bring on a recession by restricting credit or the Fed can see a boom by opening the money spigots wide).
 
“The primary trend is the great tidal trend of the market. When the tide is coming in we term it a bull market. When it is going out we call it a bear market. One of the basic tenets of Dow theory is that the primary trend of the market cannot be manipulated. That’s a point that every investor must understand. The primary trend is more powerful than the power of the Federal Reserve, Congress, and the president combined. When the primary trend of the market turns down (as it did early 1973) stocks will decline until the market discounts the worst that can be seen ahead. When the primary trend turns up (as they did in late 1974) the market will rise until the best that can be seen ahead is fully discounted in the price structure.
 
“But the point I want to get across to subscribers is that once the direction of the primary trend is set, the market will fully express itself in the primary direction. The primary trend may be held back for a while, secondary reactions may interrupt the primary trend, but ultimately the trend will run to conclusion, it will express itself fully.”
 
Russell, Richard, Dow Theory Letters, January 24, 1990, Letter 1035, 2
Keep in mind that Dow theory isn’t a cure all for investment success. As aptly stated by yet another great Dow Theorist Robert Rhea in his book “The Dow Theory," he states:
 
“The Dow theory is not an infallible system for beating the market. Its successful use as an aid in speculation requires serious study, and the summing up of evidence must be impartial. The wish must never be allowed to father the thought.”
 
Rhea, Robert, The Dow Theory, 1932, Barron’s Publishing, 26
Rhea is known for having called the market bottom in 1932 with the publishing of the book The Dow Theory as well as in his newsletter Dow Theory Comment. Despite the clarity in the fact that Dow Theory is not “infallible” the point is made that the use of Dow Theory has the significant value of synthesizing all current and foreseeable economic, political, and social information. Rhea quotes Hamilton with the following thoughts:
 
“The Averages Discount Everything -- The fluctuations of the daily closing prices of the Dow-Jones rail and industrial averages afford a composite of all the hopes, disappointments, and knowledge of everyone who knows anything of financial matters, and for that reason the effects of coming events (excluding acts of God) are always properly anticipated in their movements.”
 
Rhea, Robert, The Dow Theory, 1932, Barron’s Publishing, 19
For the fact that Dow Theory is supposed to include all information, there is little reason for me to speculate on the reasons why and how the market will do what I interpret the averages to be saying. Furthermore, the idea that Dow theory is about a bunch of lines is an unfair assessment at best. Suffice to say, Dow Theory is founded primarily on values then market sentiment and finally explained in a technical fashion (using lines.) Those wishing to understand the value component of the theory can find it throughout the New Low Observer website. However, keep reading for more insight on how value plays a role in your investment strategy.

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Dow Theory

Posted on February 22, 2010 by | Comments Off on Dow Theory
Although the markets have been relatively quiet in the last few weeks, according to Dow Theory, the Dow Jones Industrials Average and the Dow Jones Transports Average have been demonstrating classic conditions that would allow us to determine if the market will continue beyond the prior highs set in January or continue lower.
The Dow Jones Industrial Average is the measure by which everyone gauges “the market.” In the chart below, since the January 19th peak of the Industrials, the market declined until the February 8th bottom. After February 8th, the Industrials managed to exceed the rally high of 10,296.84. By exceeding the high of 10,296.84 and the 50% level of 10,368.83, the Industrials have demonstrated a bias towards going higher rather than lower.
For the Dow Jones Transportation Average, the peak of January 11th and the trough of February 8th gave us a decline of 469.97 points or 11.02%. When the index bottomed on February 8th, it was able to exceed the 3993.12 level, which is a classic Dow Theory indication that the index is going back to the old high of 4262.85. Ideally, in the chart below, if the index could stay above the 50% level (red horizontal line) and finally the 3993.12 (blue horizontal line) then we could expect the Transports to go back to the old high and possibly beyond 4262.85.
In order for Dow Theory to work, we need both the Industrials and the Transports to confirm the action of each other. So far, we’ve seen the Industrials confirm the decline started by the Transports on January 11th with a declining pattern on January 19th. After both indexes started trending downwards they both had significant rallies within the downward trend, which peaked at 10,296.84 and 3993.12. Both indexes bottomed on February 8th and moved above the rallying peaks and the 50% ranges within the previous downward trends. All of these confirming moves point to the prospect of a higher market.
The only holdout is that the Industrials went lower today (Feb. 22nd) while the Transports continued higher. From my experience, since the bottom in March 2009, I have noted that the Transports have led the way with the Industrials ultimately confirming the direction. However, this current move down, by the Industrials, while the Transports moved higher has to be taken into consideration. Any non-confirmation could lead to a major change in the trend.
The Industrials now need to stay above either the 10,368.83 or 10,296.84 while at the same time going above 10,402.34 in order to confirm the Transports’ move higher today. Alternatively, if the Industrials break down from here, falling below the 50% and rally peaks, then the Transports should follow in a similar fashion.
It should be noted that the current market action is dancing around my calculations of 10,302 being the 50% level for the Dow Industrials peak of October 2007 and the trough of March 2009 as indicated in my May 2009 posting. It is not surprising that we’re witnessing listless market action at this time. Market participants large and small are deciding if they should capitulate to the trends since March 9, 2009 or get out at a theoretical break-even point. Remember, the 50% level of the previous decline is an approximation of the average price paid by a majority of the current market participants. Is there enough momentum to keep the market going higher? Since March 9, 2009 the Transports have told us the answer to this question. We’ll have to see if this continues to be the case going forward.
-Touc

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Posted in Dow Theory, Dow Theory Confirmation, Dow Theory Non confirmation