Category Archives: Dow Theory

Dow Altimeter Review

As the Dow Industrials meander near all-time highs, it is necessary to review Edson Gould’s Altimeter for the index.

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Dow Theory

On September 30, 2013, we posted our Dow Theory analysis.  In that assessment, we acknowledged that our June 2013 review of Dow Theory was incorrect.  Additionally, we pointed out the importance of using Dow Theory as an asset allocation tool rather that a strict “buy” or “sell” indicator.  A couple of excerpts appear below:

“Since June 21st, as indicated in the chart below, the Dow Industrials and Dow Transports have managed to achieve successive new highs in early August 2013 and mid-September 2013.  In addition, the call for a bear market came slightly before the bottom in the market in late June 2013.”

“In short, we use Dow Theory indications as asset allocation signals rather than strict buy/sell signals.”

Accepting the reality that we were not in a bear market was challenging.  However, realizing it in enough time, along with the fact that Dow Theory is used as an allocation tool, has spared us excessive losses and/or missed opportunities.

Traditional Dow Theory

Recently Dow Theory has registered a confirmation of the bullish trend.  On May 12, 2014, the Dow Jones Industrial Average confirmed the new highs in the Dow Jones Transportation Average.  In fact, on the same day, both indexes made new all-time highs.

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That this is still a bull market requires a review of various factors that could be at play, both positive and negative.  As an example, already the Dow Jones Industrial Average has increased +151% since the March 9, 2009 low.  The amount of the increase is less than the average for the period of 1836 to 1914, a time when the Federal Reserve never existed.  As stated in the article titled “Is the Fed Responsible for the Stock Market Rise Since 2009?” the average increase when the Federal Reserve didn’t exist was +167%.  This suggests that the current rise may have some room to go on the upside.

Dow Theory Reconsidered

There are many who follow the traditional Dow Theory which is really a refined version of William Peter Hamilton’s writings from his Wall Street Journal and Barron’s newspaper columns as well as his book Stock Market Barometer.  The theory itself is generally sound.  More often than not it is the interpreter of the theory that gets it wrong.  However, we can’t help but feel it necessary to point out the specific words of Charles H. Dow which possibly leads to a market theory slightly different from what the legions of modern Dow Theorists are willing to accept.

The following excerpts from the Wall Street Journal outline Dow’s theory on the role of the industrials as it originally was stated:

“This is preeminently the period of industrial speculation, yet the creation of industrial stocks has become pronounced only within a year.”

“…it follows that there must be a very strong body of [venture] capitalists prepared at present to resist anything like a collapse in the industrial market and to promote by every means in their power firm or advancing prices for the market as a whole.  and this effort on their part is being powerfully supported by the excellent conditions of practically all branches of trade.”

Dow, Charles H. Review and Outlook. Wall Street Journal. April 22, 1899.

Our interpretation of the preceding quotes is that industrial stocks were, in 1899, considered to be the equivalent to modern small cap stocks which are more speculative in nature and often prone to manipulation and collapse.  The best confirmation of this concept is found in the following New York Times quote:

“Our London correspondent, in yesterday’s Financial Supplement, gave expression to the feeling which the English investor or speculator very naturally has as to the securities that usually go under the title of industrials in our markets.  It is one of distrust and hesitation.  It would be very strange if it were not.

“As to the investor, we suppose that no one on this side of the water would claim that our industrials, taking them ‘by and large,’ the older with the new, the more solid with the more inflated, can be regarded as ‘investment’ securities.”

New York Times. “The Industrials and The Boom”. March 14, 1899. page 6.

By most measures, the New York Times article, from one month earlier in 1899, confirms our view that industrial stocks were of low quality.  Now we need to see what Dow intended for the role of transportation and industrial stocks.

“…railway [transportation] stocks generally occupy a position much stronger than that held by the industrials.”

“The growth of the business of the country accrues on the old stocks [transportation stocks].  The Industrial list occupies an entirely different position.  There has been a very large creation of securities [initial public offerings].  Stocks have been bought on very limited information as to the value of the property acquired.  Attack of these stocks brings selling from those who know little in regard to the worth of what they have bought; also from those who got in at low figures [company insiders] and who propose to get out as well as they can.  This is the ideal condition for bear attacks, checked only by the possibility of not being able to borrow stock [for short selling].  The thoughtfulness of promoters [investment banks] in providing ample capital relieves this danger to great extent and will relieve it altogether when the new Industrials come to be distributed.”

Dow, Charles H. Review and Outlook.  Wall Street Journal. May 31, 1899.

Our views is that Dow’s theory was intended to be based on blue chip high quality stocks to be compared against small cap speculative stocks.  At the time, railroad stocks were the “old stocks” that had a blue chip status while the industrials were the newer [non-railroad] more speculative stocks.  We no longer live in a world where railroad stocks dominate the landscape of companies to invest in. Also, transportation stocks generally don’t provide consistent and/or rising dividend payments as was the case of railroad stocks in the last quarter of the 1800’s.

What would be the equivalent indexes of Dow’s comparison between old blue chip stocks to newer more speculative stocks? We believe that the Dow Jones Industrial Average qualifies as the blue chip barometer and the Russell 2000 small cap index qualifies as the speculative barometer.  Using all of the other elements of Dow Theory except for the Dow Jones Transportation Average, we believe that we would be following Dow’s theory exactly as it was intended.

Just to reiterate, Dow was not specifically concerned with the comparison between industrial stocks because they made the goods and transportation stocks because they shipped those same goods, a popular and logical story that is expounded on what Dow had intended.  However, based on the quotes above, we believe Dow was comparing companies of older blue chip quality that were well established and could be relied upon for their dividends in contrast to newer companies with little in the way of verifiable earnings, nascent but unstable dividends and highly susceptible to manipulation (i.e. small illiquid stock).

If we look at a comparison between the Industrials and the Russell 2000 index, the picture is very different from the confirmation of the bullish trend in the review of the transportation and industrial index above.

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As can be seen above, while the Dow Industrials has managed to exceed the previous peaks of December 2013 and April 2014, the Russell 2000 has not been able to exceed the peak of March 2014.  Under the rules of Dow Theory, this would be considered a non-confirmation of the rising trend.  However, this does not signal a new bear market.  Instead, it only suggests that investors remain cautious about new investments.

A bear market would be signaled if the Dow Industrials and Russell 2000 were to simultaneously decline below the previous retracement levels during the rise from the March 2009 low to the current market levels.  In the chart above, the initial warning would come if the Russell 2000 and Dow Industrials declined below their respective February 2014 lows.

Unemployment Rate: Our Downside Target Has Been Met

There aren’t many who are convinced that the recession ended in June 2009 and that the jobs numbers are real, as opposed to contrived.  Most investors believe that the economy is still in a recession, which has been masked by Federal Reserve stimulus and that positive jobs data is strictly a ploy by politicians to hold on to whatever perceived powers that they have.

Our take on these topics is most accurately reflected in several articles that we wrote in real time with unflinching candor and little care for conspiracy theories.  On the matter of Federal Reserve stimulus being the reason the stock market rose, we have said the following:

“…those that claim ‘this time is different’ aren’t trying hard enough to prove their claim false. A cursory review of market data during the periods from 1860 to 1914 makes it clear that declines of nearly -50% or more are likely to retrace +66% to +100% of prior declines. This pattern has been easily demonstrated in the periods after 1914. However, we’re only trying to illustrate that the acceptance of the Federal Reserve’s role as the leading cause of the current +69% retracement of the prior decline (2007-2009) is false (January 19, 2011).”

The above point was reiterated in our more detailed revision to the same article on February 17, 2014. On the topic of the recession and its end, we have not minced words about the prospects.  Additionally, we have steered away from the belief that the economy, if in recovery, should exhibit a low unemployment rate similar that of the booming economy of 2006/2007, which was built on excess in many sectors.

On August 21, 2009 (found here), we said the following about the recession:

“Implicit in my discussion of the IPI is that we are at a turning point for the economy. Based on the combination of the Dow Theory confirmation of July 23, 2009 and the IPI turning up from the June low, I will have to guess that the National Bureau of Economic Research (NBER) is going to proclaim June 2009 as the official end to the recession. The end to this recession will be lackluster and questioned from all corners. Additionally, the stock market will only follow the pattern of a cyclical bull market (bear market rally) within a secular (long term) bear market.

I doubt that the general public will agree that the recession is over since jobs will not be as plentiful as the past. However, from the standpoint of an economist the recession is over provided the IPI June low is sustained over an extended period of time.”

We were 13 months ahead of the National Bureau of Economic Research (NBER) on our call that June 2009 would be considered the end of the recession, based on what the NBER looks at (NBER announces end to recession on September 20, 2010).

What is the connection between calling an end to the recession in real time and our work on the topic of the unemployment rate?  First, we are using data reported by the government that is frequently revised.  Second, we apply Dow Theory to arrive at what we believe to be reasonable estimates of future trends.  Do we always fall for our voodoo economics?  We hope not, however, Robert Rhea’s book Dow Theory Applied to Business and Banking suggests that Dow Theory has a broader application than simply stock indexes.

On July 26, 3013 (found here), we said the following of the Unemployment rate:

“According to Dow Theory, expectations of how low unemployment should go are far more reasonable without the requirement of a economic boom that is followed by a bust.  According to the chart of unemployment below, the most realistic scenario for how low the unemployment rate could go is 6.9%.

“Applying Dow Theory’s 50% principle suggests that the best we could expect for the unemployment rate, on the downside, is for 6.9%.  It is important to understand that the 10% and 3.8% unemployment rates are undesirable scenarios.  The 10% unemployment rate is in the depths of a “recession” and the 3.8% unemployment rate at the height of a overextend economic boom.”

What has transpired in the unemployment rate since our July 26th article?  Our downside target of a 6.9% unemployment rate has been achieved. Again, we understand the conspiracy talk of the numbers being made up for the purpose of some politician to rally for more votes come election time.  However, such arguments are a waste of time.   Our view is that we need a detached perspective in order to come up with reasonable estimates.

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So what do we make of the above chart?  In general, since all downside targets have been met, our next line of reasoning is basically a guess, at best.  However, we believe that our prior line of reasoning with a detached view might serve us well in what might come.

One item that stands out is the 2006 to 2007 low of 4.40% unemployment.  This was approximately 12% below the ascending Dow Theory downside target of 5.87%.  As the current level of unemployment is at or near the same ascending 5.87% level, we have looked at the point where the unemployment first touched the 5.87% line and then calculated 12% below that level as a worst case scenario.  Based on this line of reasoning, the next downside target should be 5.90%.

Given our prior experience with Dow Theory and downside projections, any decline in the unemployment rate below 5.87%-5.90% would be exceptional with only the 4.40% and 3.80% levels as mere reflections of an overextended economic boom which should be followed by an equally impressive bust.

“Scary” 1929 Chart Says Little About the Future

On February 11, 2014, Mark Hulbert of MarketWatch.com posted an article titled “Scary 1929 Market Chart Gains Traction (found here)”.  In the article, Hulbert suggests that the critics of the chart, which shows a parallel between the current market action since July 2012 and 1928-1929, are running out of explanations as to why the chart doesn’t have merit.

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One aspect missing from the Hulbert article is what it takes to get from the most recent high of 16,588 to the 1,658 level on the Dow Jones Industrial Average.  In order to lose -89% in value, the Dow would need to decline first to 15k, 14k, 13k etc.  Leaving out these important hurdles on the downside ignores a wide swath of goings-on that needs to occur in between now and the doomsday low.  To fill the void that is unexamined by the Hulbert article, we’re going to review the various ways that the Dow Jones Industrial Average could decline to new lows.

Before offering our downside take on the market, we’d like to refer you to some basic issues that are mandatory to understanding how the stock market decline from 1929 was an anomaly, at best.  In previous work on the topic, we’ve addressed reasons why the 1929 stock market decline of -89% had more to do with reshuffling of the index by replacing stocks that had fallen significantly with new stocks that had appeared strong but were on the cusp of major declines.  Once the new stocks were added to the index they crashed hard while the stocks that were dropped from the index were at the beginning stages of recovery (2009 article found here).

In another piece, we outlined the fact that the decline of 1929 was followed by a recovery that was much faster than most investors know.  Our theory is that the multiple changes to the index artificially suppress the index on the way down and on the way up.  This resulted in the Dow taking 25 years to achieve breakeven status with 1929.  However, stocks that were not part of the index can be seen to achieve breakeven status on average by 1937.  One of our favorite examples is found in the chart of Monsanto Corp. below (2010 article found here).

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Dow Theory and the Gold Stock Indicator

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Dow Theory on Marvell Technology Buyout Rumors

Today the price of Marvell Technology increased +8.49% after news of KKR & Co. having acquired 5% of the chipmaker.  According to Bloomberg News:

“KKR & Co. (KKR) has acquired almost 5 percent of computer chipmaker Marvell Technology Group Ltd. (MRVL), two people with knowledge of the matter said.

KKR sees the Hamilton, Bermuda-based company as undervalued and has discussed its holding with the company’s co-founders, Chief Executive Officer Sehat Sutardja and his brother Pantas, said one person, who asked not to be identified as the information is private. One scenario New York-based KKR is considering is a leveraged buyout of Marvell, though no such deal is imminent, the person said (source link).”

On our Nasdaq 100 watchlist dated June 20, 2012, we had the following to say about Marvell Technology (found here):

“Dow Theory suggests that the following are the downside targets for Marvell:

  • $10.61
  • $7.54
  • $4.47

So far, Marvell has fallen within 6% of the $10.61 target, however, it has not breached that point thus far.  We’d be buyers of the stock at $8.25 with little regard for downside risk at that point in time.”

Since June 20, 2012, Marvell has had the following price performance:

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If measured by the very first day that Marvell fell below $8.25, the stock has increased +66.18% in just over one year ($7.57-$13.03).  However, if Marvell were measured based on the price before the announcement of KKR’s interest in the stock, the increase in the stock has been +45.57%. 

From our perspective, considering Marvell undervalued after a +45% run up in the price is a stretch.  However, we suspect that KKR will try to squeeze out as much of this stock as possible.  Charles H. Dow, co-founder of the Wall Street Journal, has the following to say on this particular topic:

“It is a matter of comparative indifference with a large operator whether the stock which he is handling is a point or two higher or lower.  The thing which is important is whether the public follows up the advances so that he can sell (Dow, Charles H. Review and Outlook. Wall Street Journal. June 29, 1899.)”

In this case, the large operator is KKR & Co.  Their goal is to see that Marvell rises as much as possible after they have taken a sizable position.  One method to do this is to announce, through major channels of communication with unnamed sources, that they have taken a sizable position.  What should happen next is continued speculation of whether or not Marvell is acquired by a competitor or another private equity firm, ultimately pushing the stock price higher.  Unfortunately, those relying on such information may be caught holding the bag if all the rumors are proven to be just that.

It is Dow Theory that has pointed us in the direction of when to look to acquire or accumulate stocks and it is also Dow’s theory that suggests when to be cautious and possibly sell.  For now, Dow Theory indicates that the fair value of Marvell is $14.58.  Exceeding the fair value target offers up significant opportunity.  Remember, a large operator like KKR isn’t aiming for a “point or two higher.”  If the rumors are true, KKR probably has their sights set on $22 or above. However, any price above $14.58 should be considered speculation, at best.

“Affairs are easier of entrance than of exit; and it is but common prudence to see our way out before we venture in.” –Aesop

Dow Theory

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Dow Theory: Buying in Scales

Reader J.P. asks:

“What is your recommendation for taking a position.  All in, or 1/2 in and average up or down. I can't find anything on this on the website.”

Our Response:

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Dow Theory: Secondary Reactions

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Gold Stock Indicator: September 18, 2013

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Dow Jones Industrial Average Additions and Deletions 1884-2013

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Silver: Downside Targets Met

As early as May 5, 2011, when silver was trading at $35 an ounce, we’ve maintained the view that the prospect of silver, in the form of the exchange traded fund iShares Silver Trust (SLV), falling below $20 was well within the realm of possibility (article here).  At the time, we said the following: Continue reading

Precious Metal Stocks: September 7, 2013

Below is a list of gold and silver stocks that are ranked based on their upside potential according to Dow Theory estimates of fair value.  As with any investment consideration, the stocks that have the highest percentage upside potential should be considered the highest risk with the most volatility.   We believe that stocks with upside potential below +143% are the most likely to achieve their Dow Theory fair value targets. Continue reading

Dow Theory and the Unemployment Rate

For some, the economy has not fully recovered until the unemployment rate is “back where it was” when the economy was booming.  Unfortunately, there are key issues with this notion. Continue reading

Investing in Foreign & Emerging Stock Markets

Subscriber R.G. asks:

“If emerging markets possess such a gambit due to their lack of similar history in the past how can we analyze the markets in order to capitalize on their surges of demand which quickly taper[s] off?”

Our general view on foreign and emerging markets is similar to that of Warren Buffett’s when he said:

“'If I can't make money in the $4 trillion US market, I shouldn't be in this business. I get $150 million earnings pass-through from the operations of Gillette and Coca-Cola. That's my international portfolio’ (source: Ellis, Charles D. Wall Street People. page 56. link here.)”

There seems to be little need to invest in foreign or emerging markets.  However, if there is a desire to invest in foreign markets then Dow Theory provides a reasonable template for how to approach investing in such a market.  In a section titled “Dow's Theory True of Any Stock Market,” William Peter Hamilton says the following:

“The law which governs the movement of the stock market, formulated here, would be equally true of the London Stock Exchange, the Paris Bourse or even the Berlin Boerse. But we may go further. The principles underlying that law would be true if those Stock Exchanges and ours were wiped out of existence. They would come into operation again, automatically and inevitably, with the re-establishment of a free market in securities in any great capital. So far as, I know, there has not been a record corresponding to the Dow-Jones averages kept by any of the London financial publications. But the stock market there would have the same quality of forecast which the New York market has if similar data were available. (source: Hamilton, William Peter. Stock Market Barometer. Harper & Brothers Publishers, New York. page 14. link here.)”

When we speak of Dow Theory, we are referring to the emphasis of values, fundamentals in relation to price as they pertain to individual stocks and the stock market.  We are putting less emphasis on the strict technical analysis of the equivalent industrial and transportation indexes. 

To be clear, because we live in the United States we emphasize investing in the U.S.  However, according to Hamilton, it does not matter which country that you’re in, investors should embrace the comparative advantage of living in a country other than the United States and should become experts of value opportunities in that region.