Category Archives: Dow Theory

Dow Theory: The Beginning of a Cyclical and Secular Bull Market?

The world of Dow Theory was abuzz after the Dow Jones Industrial Average and the Dow Jones Transportation Average charged to all-time highs on March 5, 2013 (found here).  At the time, the Dow Jones Industrial Average had finally capitulated to the inexorable forces that had long since propelled the Dow Jones Transportation Average above the 2011 all-time high.  The confirmation of a Dow Theory bull market came when the Dow Jones Industrial Average finally exceeded the all-time high of 14,164 set in October 2007.

The action of the Dow Industrials and Transports has been so compelling that Dow Theorist Richard Russell acquiesced to the strength of the market on March 11, 2013 by saying the following:

“Yes, I know that this market is uncorrected during its long rise from the 2009 low, and I know that there are risks in buying an uncorrected advance that is becoming uncomfortably long in the tooth, but my suggestion is that my subscribers should take a chance (after all, Columbus took a chance) and take a position in the DIAs.”

In the same posting, Russell later punctuates the point by saying:

“I really believe that subscribers should take a flyer on this market. After all, after weeks of flirting with a new high in the Industrial Average, the Dow finally confirmed the previous record high of the Transportation Average. With the Industrials and the Transports both in record high territory, I think being in the market is justified under Dow Theory.”

By all indications, this Dow Theory bull market indication is the real deal, especially when it is endorsed by Russell’s 55 years of experience on the topic.  The implications of this signal are significant for one very important reason, this time we’ve achieved a secular bull market indication (learn about cyclical and secular trends).

Throughout stock market history, cyclical primary bull markets tend to last 2-4 years.  These bull markets require rapt attention to the nuances and vagaries of changes in the trend.  The last indication of a cyclical primary bull market was on July 23, 2009, when the Dow Industrials traded at 9,069.29.  Based on our interpretation of Dow Theory, we received a cyclical primary bear market indication on August 2, 2011 when the Dow Jones Industrial Average was at 11,866.62.

Secular bull markets, on the other hand, require very little attention and have typically lasted between 15 and 18 years.  Secular bull markets are the proverbial sweet spot of investing with the trend, where “buy-and-hold” is the rule. The two most prominent secular bull markets resulted in the Dow Jones Industrial Average increasing by 10-fold or more. From 1942 to 1966, the Dow rose from 100 to 1000 and in the period from 1982 to 2000, the Dow went from 1,000 to 11,722. If the current implications are correct, we could be on the cusp of a run to Dow 100,000.

Volume: The Lone Holdout

The three major components of Dow Theory are the Industrials, Transports and trading volume.  As described above, the Industrials and Transports have achieved the required all-time highs at (or near) the same time which would indicated that we are in a new cyclical AND secular bull market.  However, volume has been the holdout in the current move higher.

In the seminal book on Dow Theory titled The Stock Market Barometer, written by William Peter Hamilton, it says the following about trading volume, “It is worth while to note here that the volume of trading is always larger in a bull market than in a bear market. It expands as prices go up and contracts as they decline.

The average trading volume for the Industrials and Transports has been in a declining trend (contracting) since the 2009 low, as seen in the charts below.

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In order for Dow Theory to have relevance, increasing volume needs to accompany the rise of the stock market to ensure that there is sufficient participation and interest.  Unfortunately, average trading volume, as indicated in the above charts for the respective indexes, has been trending lower since 2009.  This suggests that we could only be in an extended  cyclical bull market, within a secular bear market, rather than at the beginning of a cyclical and secular bull market.  The key to understanding trading volume and its interpretation are found in the table below.

volume price interpretation
decrease decrease positive
decrease increase negative
increase decrease negative
increase increase positive

In the days before volume was tabulated for the individual Dow indexes, the New York Stock Exchange trading volume was the proxy for the market trend in conjunction with the Industrials and Transports.  Below is the  200-day average trading volume of the NYSE since 2001.

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What is evident is the dramatic rise and peak of average trading volume during the decline of the stock market from the peak in 2007 to the bottom in 2009.  However, once the market started taking off, the trading volume uncharacteristically plunged.  To emphasis the point, below we have included the charts for the cyclical bull markets from 2001-2007 and 2009 to the present.

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In the chart from 2001, we can see that NYSE average trading volume hit a peak in 2002 and then flat-lined for a couple of years until 2005.   However, as the strength in the stock market grew, the trading volume accelerated to new highs.  This was the hallmark of a true bull market run, rising prices and rising volume.

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In the chart from 2008, the average trading volume for the NYSE has had a declining trend throughout the whole bull market run from 2009 to the present.  As indicated in the table above, declining volume with increasing prices should be interpreted as a negative.  After volume has been in a declining trend for so long, the only alternative is for a dramatic increase.

When the increase in volume arrives, the question then becomes, will there be a dramatic increase or decrease in stock market price?  Will the general public’s lack of participation be the catalyst that charges the market to move higher?  This situation has to be resolved at some point.

To round out our thoughts on the potential secular bull market signal that we recently received, we thought we would compare it to the last secular bull market change in trend.  In the period from 1966 to 1982, the Dow Industrials never traded significantly above 1,000.  However, that all ended in late 1982 when the stock market broke above 1,000 and never looked back.

Below is a chart of the Industrials, Transports and NYSE trading volume from March 1982 to November 1982:

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The most important information to be gleaned from this chart is the fact that all three of the essential indicators for Dow Theory were confirming each other at a critical point in time.  They all achieved clear bull market indications by rising in unison.  The current divergence between the Dow indexes with the NYSE trading volume suggests that we will be witness to the greatest transition in the history of the stock market.

The above examination of trading volume, based on a what we believe to be reliable sources, has us concerned that a new secular bull market is not really what we’re witness to.

As William Peter Hamilton has said in The Stock Market Barometer:

“The professional speculator is no more superfluous than the pressure gauge of the steam-heating plant in your cellar. Wall Street is the great financial power house of the country, and it is indispensably necessary to know when the steam pressure is becoming more than the boilers can stand.”

The pressure in the market is building and we may be watching the beginning of the most spectacular stock market blow-off ever.  Just before an even more astonishing decline.

Dow Theory

On March 5, 2013, we got a declarative indication from Dow Theory suggesting that we are now in a new primary bull market that has cyclical and secular implications.  As seen in the chart below, both the Dow Jones Industrial Average and Dow Jones Transportation Average have reached new all-time highs, designated by going above the respective dashed lines.

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NLO Q&A

Subscriber F.H. asks:

“[Have you] ever consider[ed] constructing a market trend indicator like Richard Russell’s PTI?”

Our Response:

This is a great question and one that we’ve examined in the past.

We are familiar with Russell's Primary Trend Indicator (PTI).  In fact, we know the exact constituents of the indicator.  According to Richard Russell, editor of The Dow Theory Letters since 1958( www.dowtheoryletters.com), the PTI is a “technical spectrum of the stock market” that cannot be manipulated.  Russell goes on to say "...you can fool one or two of these technical items, but you can’t fool all eight of them, and that’s what the PTI is all about."  The goal of the indicator is to provide solid indications of market direction that cannot be manipulated.

As a subscriber to Russell's Dow Theory Letters, you are well aware of the many times that the PTI was right and Russell was wrong about the direction of the stock market. However, we're more concerned with the fact of how much advantage does the PTI provide compared to simply using Dow Theory.

Here is what we’ve found.  According to Dow Theory, on July 23, 2009 a new cyclical bull market began.  At the time we recommended investing in the highest weighted stocks of either the Industrials or Transports index or the purchase of ETFs for the Industrials (DIA) or Transports (IYT) (article found here).

On the other hand, the Primary Trend Indicator (PTI) gave the first hint that we were in a cyclical bull market on August 25, 2009.  In addition, the PTI didn’t give the “all clear”, in terms of being in a bull market, until November 30, 2009 (as seen in chart below).  In fact, a good technical analyst would have had tremendous difficulty in getting a clear indication based on the PTI until after the December 8, 2009 rebound.

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There is an alternative view on interpreting an earlier signal than the Dow Theory indication using the PTI.  However, you would need to apply Dow’s theory in order to properly achieve the earlier signal based on the PTI movement.  Using the purple line above, an individual could have interpreted that a cyclical bull market tentatively started as early as May 4, 2009, when the PTI exceeded the January 2009 peak.  Subsequent to the May 4th peak, the PTI did not decline below the 89-day moving average on May 27, 2009, suggesting that more upside existed.

However, when we refer back to Russell’s June 3, 2009 issue there is no indication that a tentative new bull market was in play.  No mention that May 4, 2009 or May 27, 2009 were possible indications of a new bull market in stocks.  In fact, Russell commented that “…ridiculous but unseen green shoots is now repeated everywhere. I’ve stated that a true bear market bottom usually requires many weeks or even months before the crowd turns bullish.”  This comment along with the picture of a bear at the top of his newsletter was the only indication that we had that we were still in a bear market, according to Richard Russell.

Because we have studied the PTI in detail, we've determined that it is not worth including in our work.  In fact, we’ve found that it is more noise on the market when compared to correct, albeit conservative, interpretation of Dow Theory.  If we get Dow Theory right, then we don’t need another indicator to follow that could potentially confuse our primary indications based on Dow’s work.  Yes, we will take in as many views as possible, however, we will rely on Dow Theory as the primary indicator for market direction.

Finally, to create an indicator that is supposed to be impervious to manipulation while at the same time practicing Dow Theory is doubling the effort necessary in watching the movements of the market.  We’ve outlined in extensive detail the role that manipulation plays in the stock market and how the interpretation of Dow Theory mitigates the most extensive manipulation possible (found here).

Subscriber F.H. Asks:

In regards to our recent posting of the 2012 Portfolio Performance Review F.H. asks, “…I am wondering if the methodology will allow this streak to continue. the process, as I understand it, is to buy stocks at their lows, hold them for a significant gain, and then sell a portion of the position but retain some % of original principal in the investment. won’t the portfolio eventually have such a large percentage of these residual holdings that the incremental effect on returns from the new positions will be overwhelmed?”

Our Response:

In theory, the primary drawback would be that we’ll be working with the same amount of cash over an extended period of time whenever we sell the principal.  However, we’re comfortable with continually adding new cash to the portfolio so that we are not faced with the very real potential of our residual holdings dwarfing our capital base.

Our strategy is the literal application of a concept that is outlined in the book Rocking Wall Street by Gary Marks.  In an interview on June 2, 2007 with Financial Sense Newshour host Jim Puplava (found here), Marks gives insight as to the reasons why an investor might want to employ the strategy that we’ve outlined with selling the principal and letting the profits run.  The interview is so good that we’ve indexed the various topics covered in the interview below.

minutes topic
3:57-4:57 Art and Craft of Investing
6:48-8:25 Investing is About Less Risk Over Time
16.03-17:13 Emotional Risk causes Gambling Modality
17:15-19:28 Myth of Tax Savings from Buy and Hold
19:29-21:39 Myth of Buy and Hold
25:32-28:10 Risk to Real Estate
28:11-31:57 Cash as a Hedge
38:58-42:05 portfolio construction & life balance

The discussion of the “Art and Craft of Investing,” as described by Marks, is exactly what we’re practicing and what we believe will give any investor the benefits that are claimed that the stock market can offer.  Our approach is in stark contrast to the belief that if you practice Dow Theory you must go all in when the signal is bullish and sell everything when the signal is bearish,  but at the same time you’re supposed to compound your way to investment wealth.

We agree with 95% of the strategies described by Marks in the Financial Sense interview.  After weighing the merits of various investing approaches, we’ve tried to responsibly provide methods for investing while limiting the risk of excessive loss.

Dow Theory: Waiting for Confirmation

Today the Dow Jones Transportation Averaged (DJT) closed at a new all-time high.

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Technical Review: Carbo Ceramics (CRR)

Carbo Ceramics (CRR) was one of the companies that appeared at the top of our dividend watch list for many weeks beginning in February 2012. The watch list served as a beginning point for our research and we took a position in August (found here) at $65.02 (green arrow on chart below). Within three months, we saw shares of CRR rally to $74, a +13.8% gain. As such, we ‘hedged’ our position by selling the principal (found here) and let the profit run (red arrow on chart below).

Recent activity in Carbo Ceramics price suggests that, on a technical basis, the decline is over. Though a rally to its intraday peak of $180 is not expected, we believed there is a good opportunity for those interested in a short to medium-term speculative position in the stock.

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In our view, the biggest bull case, on a technical basis, is that the 50-day moving average has crossed above the 150-day moving average creating what some call a "golden cross." We rely on the 150-day versus the more popular 200-day moving average for the fact that it is the road less traveled and provides an indication ahead of the crowd.

Currently, shares of Carbo Ceramics are trading just above the 50-day moving average, making this an ideal short-term transaction. For those who wish to trade this generally significant technical pattern, we’d consider selling if shares close below the 150-day moving average or if the stock gains +10% or more.

From a fundamental standpoint, Carbo Ceramics (CRR) provides long-term holders of the stock with the following attributes:

  • According to Value Line Investment Survey, the fair value for CRR is 14 times 2012 cash flow of $6.50, or a stock price of $91, a gain of +14% above the current price of $79.64. As an alternative, if the estimates by Value Line are correct, the 2013 fair value figure is $100.10, a potential gain of +25.69%.
  • Value Line indicates that Carbo Ceramics has increased the dividend for 12 consecutive years in a row.
  • Carbo Ceramics book value has had an annualized growth rate of +14.73%.
  • Carbo Ceramics has no debt

What Is the Downside Risk If I Want to Hold CRR for the Long-Term?

Dow Theory has the following downside targets for Carbo Ceramics:

  • $61.34
  • $44.39
  • $27.43

Based on the work of Edson Gould, Carbo Ceramics has the following Altimeter:

CRR 1-14-2013

Carbo Ceramics would have to fall to $70.20 in order to be considered a buy using the Altimeter above. However, as has been the case in the past, seldom does the Altimeter decline to the buy level and then immediately reverse to the upside. therefore we’d expect a push below the $70.20 level for good measure.

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Edson Gould’s Speed Resistance Lines have $65 as the downside support level.

The most conservative of the three downside targets mentioned above is the Dow Theory level of $61. This seems be the most appropriate level to consider a first, or second, purchase if the desire is to hold Carbo Ceramics for the long-term.

The Convergence of Stock Market Forces

In our last posting of Dow Theory we mentioned the need for caution on premature calls of a new bull market.  We pointed out that with the Dow Transports and Dow Industrials so close to their respective all-time highs, investors should wait for confirmation of both indexes before getting too excited.  Now we’d like to introduce another observation of Charles H. Dow’s with regards to stock market cycles which might be the perfect antidote to further movement higher.

In June 2010, we published an article titled “The 4 to 4 1/2 Year Market Cycle” (found here).  In that article, we quoted Dow as saying the following:

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Dow Theory Update

We may be on the cusp of a Dow Theory cyclical and secular bull market signal.  However, where the rubber hits the road when it comes to Dow Theory is discretion and confirmation.  Discretion is needed for the purpose of avoiding frequent and erroneous calls. Confirmation is needed to ensure the quality of the analysis. We’re hoping that the chart below clarifies what investors need to know about the recent stock market activity.

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Dow Theory: Secular and Cyclical Markets

We often mention the concept of secular and cyclical markets in our discussion of Dow Theory.  So far, we believe that we’re in a secular bear market owing to the fact that the Dow Jones Industrial Average and Dow Jones Transportation Average cannot meaningfully exceed prior peaks.  However, we feel it is necessary to provide a graphical representation of what a secular and cyclical market looks like.

Keep in mind that active analysis of Dow Theory provides cyclical indications of moves in the market which usually lasts from 2 to 6 years.  Depending on the circumstance, which usually hinges on the quality of analysis, Dow Theory also provides an indication of secular trend changes in the market.  However, secular trends usually encompass periods from 16 years to as many as 24 years.

In this assessment, we’re assuming that Dow Theory was only able to provide bullish signals at 1/4  of the move from the bottom and bearish signals 1/4 of the move from the top for each cyclical trend.  This is a very generous assumption in favor of those who are critical of the validity of Dow Theory as a market forecasting tool.

Historical Perspective and Highlights

First, let us start with the history of stock market secular trends from 1906 to the present broken into the various cyclical moves that can be easily identified (detailed review of stock market from 1860-1906 found here).  The first secular trend is from 1906 to 1924 in what is clearly a bear market.  Our definition of a secular bear market is the inability of the Dow Jones Industrial Average to exceed a prior high level for an extended period of time.  As seen in the chart below, the 1906 to 1924 period certainly fits the bill.

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The secular bear market from 1906 to 1924 was 18 years long.  As indicated with the arrows (green arrows for cyclical bull markets and red arrows for cyclical bear markets) there were many instances where an investor could have avoided the losses of buy-and-hold if Dow Theory was applied.

What should follow a secular bear market is a secular bull market, however, the period from 1924 to 1942 was a combination of both with a quasi-secular bull market from 1924-1929 and a quasi-secular bear market from 1929-1932.  Charles H. Dow has commented that markets move like a pendulum, swinging from excessive gains to excessive losses. S.A. Nelson has specifically outlined Dow’s point by referring to the extremes of these swings in the market as “artificial advances” and “artificial depressions.” (found here).  William Peter Hamilton’s account of Dow Theory on November 17, 1924 was as follows:

“At the opening of the week the industrial and railroad share averages simultaneously broke through all previous points of resistance this year so decisively as to constitute by the Dow theory of analysis as emphatic and indication of a major bull market as has ever been discovered in the long history of the movements of these averages.  By the end of the week the industrials were up approximately three points and the railroads two points through their previous best prices this year.  That spells a dynamic movement of impressive proportions and unquestionably it forecasts in due time a further sustained upward movement that will eventually better every price yet seen.” (source: Hamilton, William Peter.  “What of the Market?. Barron’s. November 17, 1924. page 2.)

The compressed period of time that the Dow Industrial Average rose from 100 to 381 might have been the first clue that the gains were not sustainable.  As an example, in the secular bull market from 1942 to 1966, it took 12 years to rise an equal percentage amount.  Likewise, in the secular bull market from 1982, it took the Dow Industrials 13 years to equal the percentage gains made from 1924 to 1929. Fortunately for some and unfortunately for many, the 1924-1942 period provided both secular moves within a single secular timeframe.

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Shortly before his passing, William Peter Hamilton, Dow Theorist and fourth editor of the Wall Street Journal, wrote his famous “Turn of the Tide” editorial in the Wall Street Journal and Barron’s indicating that the bull market move had ended when the Dow Industrials were trading at around 325.17 (source: “A Turn in the Tide”. Barron’s. October 28, 1929. page 14).  The follow-up analysis of a new bull market came from Dow Theorist Charles J. Collins who suggested that “…failure on the part of the rail average to confirm the weakness in the industrial list suggested a rather strong foundation to the market (source: Collins, Charles. Barron’s. August 8, 1932. page 5)”.  At that time, the Industrials were trading at the 67.71 level.  The subsequent move in the Dow Industrials to the March 1937 high was over +180%.  Likewise, the decline that followed to the 1942 low was equal to -48%.

With the stock market reeling from the “adjustment” from the 1929 peak and crash, the next move in the market should have been a secular bull market.  The next move in the market was, in fact, a secular bull market that ran from 1942 to 1966.  The ideal for any market forecaster is to be able to distinguish a secular bull market from a cyclical bull market within a secular bull trend.  The reason for this is because, if correct, investors can stay fully invested through the entire secular bull trend while taking advantage of short-term declines with new investment of funds.  Cyclical bull markets within a secular bear trend require investors to sell some or all of their stock to be repurchased at the next Dow Theory cyclical bull market indication.

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The secular bull market move from 100 to 1,000 was every investor’s dream.  However, the stock market collapse and the “Great” Depression that preceded it kept the majority of investors out of the market until the final run-up from 1962 to 1966.  Naturally, just as the majority of investors became confident of the secular bull market, the secular bull market was on its last leg.  Richard Russell had the following to say of the 1966 Dow Theory bear market signal:

“Having failed to hit new highs on the April [1966] recovery, the two Averages again retreated.  On May 5 the March lows were penetrated to the accompaniment of heavy volume.  Based on the method formulated by Charles H. Dow at the turn of the century, the two Averages on May 5 gave the signal for a primary bear market.  We now know that the February-March [1966]decline was the first leg of the bear market, and the March-April [1966] rise was the first (upward) correction.  the second leg began in late April and remains in force (source: Russell, Richard. “Bear Market Signaled Under Dow Theory”. Barron’s. May 9, 1966. page 31.)

The secular bear market that followed from 1966 to 1982 seemed brutal on a relative basis.  However, it was no worse or better than the secular bear market from 1906 to 1924.  Much of the reason that the period from ‘66-‘82 seemed particularly difficult is mainly due to how recent it occurred rather than the relative depth in the market decline.  It lasted from 1966 to 1982 or 16 years.

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The secular bear market from 1966 to 1982 experienced five cyclical bear markets and four cyclical bull markets.  For all intents and purposes, it was among the worst times to be a buy-and-hold investor.  However, our favorite article in review of this period is Jeremy Siegel’s  “Nifty Fifty Revisited” which showed what would happen if an investor had bought and held the hottest stocks from the peak in the market in 1972 (those stocks with the highest P/E ratios) and reviewed their performance until 1995 (PDF found here).  There is merit in buy-and-hold investing and for our money the Siegel article makes the case quite well, especially if the investor happens start investing in a secular bear market and has an investment horizon with a minimum of 20 years.

The secular bull market that followed the secular bear market of 1966 to 1982 lasted from 1982 to 2000 and saw the Dow Jones Industrial Average rise from 1,000 to approximately 11,500.  Although we’ve indicated that the year 2000 was the end to the secular bull market, a valid case can be made for 2007 as the end of the secular bull market.  In either case, the Dow Industrial Average is marginally above the 2000 level or below the 2007 peak.

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Our interpretation that we’ve been in a secular bear market since 2000 or 2007 only holds water as long as 11,500/14,164 is the range that the Dow Jones Industrials trades in.  A common timeframe for our version of secular periods averages around 18.8 years based on the previous five periods.  This suggests that if the 2000 peak holds then the secular bear market should end in the years between 2016 to 2023.  We’re partial to the idea that the 2007 top was a secular peak.  Richard Russell had the following to say on the topic of Dow Theory shortly after the 2007 peak:

“Did last week’s market volatility make you queasy? If you believe in the Dow Theory, there was reason to be wary.  The Dow Jones Industrial and Transportation averages plunged to end-of-day lows of 12,845.78 and 4,672.35, respectively, on Aug. 16. Both then rallied. But while the industrials hit a record 14,164.53 on Oct. 9, the transports didn't come near a record, thus failing to confirm the DJIA's strength. This set up the potential for a classic Dow Theory bear-market signal” (Russell, Richard. “What Does Dow Theory Says”.  Barron’s. November 12, 2007. link here.).

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Summary on Secular and Cyclical Trends

Classic secular bull market moves typically require investors to only buy in the beginning and hold ‘til the end.  The obvious challenge is to understand and accept that the prior secular bear market should be followed by a secular bull market.  This is a difficult psychological transition for investors after experiencing four or five cyclical bear market moves over the course of 16 to 18 years.

Classic secular bear markets require timing tools like Dow Theory to keep an investor’s expectation in check with the investing environment.  Alternatively, investors who expect to buy-and-hold during a secular bear market must have a time horizon that is exceptionally long in duration and hold stocks that provide income to offset inflation and possible lack of capital appreciation.  Jeremy Siegel’s article titled the “Nifty-Fifty Revisited” is an exceptional rationale to hold stocks through a secular bear market (PDF found here).

Although Dow Theory can inform an investor of being in a secular bull and bear market after the fact, it is of greatest use at calling cyclical bull and bear markets, especially within a secular bear market. So far, we happen to be in the most ideal period when Dow Theory could be of the most benefit to investors.

more: The Stock Market from 1860 to 1906

Dow Theory: Industrial Production Index Points to Recession

The Industrial Production Index (IPI) is an important lagging indicator that is part of Dow Theory as suggested in Robert Rhea’s book Dow Theory Applied to Business and Banking.  Although seldom mentioned by modern Dow Theorists, the IPI is useful in confirming the validity of Dow Theory indications.  This explains why a Dow Theory primary bull market was not announced by Robert Rhea in the period from November 1929 to April 1930.  Although the stock market was rebounding from the “Great” Crash of 1929, the IPI was still in a declining trend,  highlighted in the red bar as shown in the chart below.

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In our last review of the Industrial Production Index on April 20, 2012, we had indicated that we’d need to see two consecutive months of decline in order for a confirmation of a recession while in a Dow Theory bear market.    Since that piece, we have not seen two consecutive months of declines.  However, as the data for the Industrial Production Index is continually updated, as much as six months into the past, we begin to see an emerging pattern. 

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Since January 2012, the Industrial Production Index has traded in a narrow range, based on the revised data.  Already the Industrial Production Index is below the July 2012 high and approaching the April 2012 low of 96.4705.  Falling below the April low could indicate that the recession had begun as early as January 2012.  The Industrial Production Index has not been mired in such a range since the end if the recession was called in June of 2009.  Additionally, the preliminary data suggests that the economic recovery has hit a snag and may be on the cusp of a full blown recession (as defined by the National Bureau of Economic Research).

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As can be seen in the chart above, the Dow Jones Transportation Average and the Industrial Production Index seem to have experiences similar troubles at around the same point in time.  True to form, the Dow Jones Transportation Index has gyrated widely to the downside with little ability to exceed the 2007 and 2011 highs.

From a historical standpoint, whenever the Industrial Production Index has peaked, 13 out of 17 times since 1920 (76.47%), the result was a recession call by the NBER.  All that is left at this point is for the Industrial Production Index to rise, fall or get revised significantly outside of the established range.  Rising or falling by a wide margin could definitively answer the question about whether we’re in a recession.  The range could be revised out of existence through the process of updating the figures. 

Our take is that there has to be a significant amount of economic growth through economic stimulus that dwarfs all prior efforts since 2007.  Outside of such efforts by monetary and fiscal actions, we believe that a recession could be considered in effect from either January 2012 or July 2012.

Dow Theory

How long does a Dow Theory Primary Bull Market last?

Recently, some followers of Dow Theory had suggested that a new primary bull market began on June 4, 2012. Those same Dow Theorists are now put in the awkward position of changing that primary bull market call to a primary bear market indication as recently as November 11th or 16th of this year.

However, when doing the math, those Dow Theorists who claimed that a primary bull market began on June 4, 2012 have very little to show for it, especially when, by their own account, a primary bear market was signaled on November 11th or 16th. To demonstrate how inaccurate that analysis was, since June 4th, the Dow Industrials has increased +4.02% while the Dow Transports increased +0.90%. Even in the period from June 4th until the respective peaks, the gains were marginal with the Dow Jones Transportation Average gaining +8.31% by June 19th without being able to exceed the 2011 peak. At the same time, the Dow Jones Industrial Average gained +12.47% by October 5th without being able to exceed the 2007 peak. The inability to exceed prior all-time highs is uncharacteristic of what one should expect of any market move deemed a “primary bull market.”

In all of the history of the Dow Industrials and Dow Transportation Averages, primary bull market moves have never lasted for only 5 months. The following examples from renown Dow Theorists suggest that any indication that a primary bull market began in June 2012 and ended in November 2012 was done so in error.

When William Peter Hamilton wrote on the topic of the primary bull market movements in his book Stock Market Barometer, he said the following:

“The average duration of six major bull swings is twenty-five months…(page 44).”

According the Robert Rhea’s book The Dow Theory:

“…a primary bull market is a broad upward movement, interrupted by secondary reactions, and averaging longer than two years (page 44).”

From E. George Schaefer’s book How I Helped 10,000 Investors to Profit in Stocks comes this conclusion:

“…in primary bull markets the duration of a typical primary up-trend might last from four to eleven years…(page 42)”

It is more likely that a primary bear market can last as little as 5 months due to panics and crashes. However, in order for Dow Theory to be worth its weight, a primary bull market should see an investor through an extended period of time (at minimum 12 to 18 months and usually 2 years or more) and not a period of less than 6 months.

Dow Theory: The Backdrop 

On August 2, 2011, Dow Theory provided us with the first primary bear market signal since the primary bull market indication of July 23, 2009.  This bear market indication came with a very interesting backdrop that is worth reviewing. On the very same day as our bear market indication (Aug. 2, 2011), the Senate passed the bill allowing for the extension of the debt ceiling (found here). The Senate vote came one day after the House of Representatives approved legislation to raise the debt ceiling to $14.3 trillion (found here).

The discussion and debate prior to the actual passage of the bill, allowing for the debt ceiling increase, suggested that the country would suffer irreparable damage if Congress didn’t come up with a solution.  Once the bill was passed, Congressional members were as giddy as can be.  There was a lot of back slapping and praise because both sides of the aisle could finally agree on something. 

Suffice to say, only three days (Aug. 5, 2011) after the “bipartisan” agreement to raise the debt ceiling, Standard & Poor's lowered the credit rating of the United States indicating that “…the downgrade reflects our view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges to a degree more than we envisioned…” (PDF found here).

We wince when politics has to enter our discussion of the markets since we know that there are no winners when it comes to such a debate.  However, we have reminded readers of the backdrop at the time of the Dow Theory bear market indication to suggest that we may actually be sitting on another “buy the rumor and sell the news” scenario when the resolution of the “fiscal cliff” arrives.  From the May 3, 2011 to August 1, 2011, the Dow Jones Industrial Average declined –5.27% and from August 1, 2011 to August 10, 2011, the Dow Jones Industrial Average declined –11.64%.  It appears the stock market anticipated that the debt ceiling would be increased and that ultimately it would be to no avail, resulting in the downgrade from S&P. 

Already, the Dow Jones Industrial Average has declined –7.5% from the October 5, 2012 high.  Are we slated for a similar reaction to the ultimate “resolution” of the “fiscal cliff” that currently overhangs the U.S.?  It is interesting to note that the increase of the debt ceiling and the “resolution” of the “fiscal cliff” will have a negative effect on the U.S. despite the two political parties’ shameless self-promotion for acting in a bi-partisan manner to come to a “resolution.”  If the S&P downgrade of the U.S. came 3 days after the agreement to raise the debt ceiling and a stock market plunge of –11% in seven trading days later, what can we expect when the “fiscal cliff” passes?

Also, keep in mind that with the announcement of QE3 on September 13, 2012, the stock market has declined as much as -7.02%.  All prior announcements of quantitative easing by the U.S. and European Union were not accompanied with almost immediate declines in the stock market. It appears that the quick fixes are having less of the desired short-term impact since it is clear that the long-term effects of such strategies are harmful and possibly irreversible.  Our article on the diminished impact of QE3 can be found here.

We can’t be sure if the past provides any lessons, however, the solution to the “fiscal cliff” may lead to an outcome that is far worse than anticipated.  While everyone in Congress was suggesting that there were going to be dire consequences to not raising the debt ceiling there were few that anticipated that the S&P would downgrade the debt anyway.  Likewise, providing a solution to the “fiscal cliff” cannot hid the fact that the U.S. is a house that is not in order.  Resolving issues like the debt ceiling with increasing the debt “limit” or the “fiscal cliff” with less cutting and more spending than initially planned, with politicians whose goal is to posture until the 11th hour, suggests that S&P’s downgrade of the U.S. debt will be looked upon in retrospect as an understatement.

Dow Theory: Bear Market Confirmation Due

Starting with the movement of the Dow Industrials and Transports, we can seen that the primary bear market began on August 2, 2011.  Since that time, the bear market rally (from the August 8, 2011 or October 3, 2011 low) has been very rewarding to anyone who followed our August 9, 2011 (found here) indication that a temporary bottom had been reached.

image

Now that there has been a substantive decline in the Industrial Average below the April 30, 2012 peak we can see that any decline below the June 4, 2012 low is the level to watch for.  Again, Dow Theory indicates that for any signal to have merit, both the Industrials and Transports must simultaneously rise above prior peaks or decline below prior troughs.  In order for us to get a bear market confirmation, we’d need the Industrials to decline below 12,101.46 and the Transports to fall below 4,847.73 on a closing basis. 

So far, the Industrials are +4.02% above the June 4th low while the Transports are +0.90% above the mid-year level.  If either of the indexes fail to fall below the June 4th level we have to put our bear market thesis on hold.

Dow Industrial Upside Targets

The decline that the Dow Jones Industrial Average has experienced isn’t out of the ordinary.  However, it is our responsibility to review the prospects of an upside target based on Dow Theory.  Taking the most recent intra-day low of 12,471.50 and projecting to the most recent intra-day high of 13,661.90 provides us with the following upside targets:

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Each move up to the 13,066.69 level carries the risk that at any point the market can easily descend below the 12,471.50.  However, exceeding 13,066.69 and especially the points above the 13,265.10 connotes the prospect that the Dow Industrials can achieve 13,661.90.

Nasdaq 100 Watch List: November 16, 2012

Below are the Nasdaq 100 companies that are within 10% of their respective 52-week lows. Stocks that appear on our watch lists are not recommendations to buy. Instead, they are the starting point for doing your research and determining the best company to buy. Ideally, a stock that is purchased from this list is done after a considerable decline in the price and rigorous due diligence.

Symbol Name Price P/E EPS Yield P/B % from low
BIDU Baidu, Inc. 92.68 20.97 4.42 - 8.87 0.95%
VOD Vodafone Group  25.27 - -0.55 7.9 1.11 1.28%
BBBY Bed Bath & Beyond Inc. 56.4 13.1 4.3 - 3.27 1.48%
MCHP Microchip Technology Inc. 29.37 27.94 1.05 4.8 2.93 1.56%
^NDX NASDAQ-100 2,534.16 - - - - 1.59%
FLEX Flextronics Int’l 5.54 7.55 0.73 - 1.51 1.65%
DELL Dell Inc. 8.86 6.03 1.47 3.3 1.63 1.94%
AMAT Applied Materials Inc. 10.15 118.02 0.09 3.5 1.74 2.01%
NVDA NVIDIA Corporation 11.38 14.21 0.8 2.6 1.53 2.06%
INTC Intel Corporation 20.19 8.81 2.29 4.5 2.03 2.12%
ALTR Altera Corp. 30.45 17.02 1.79 1.3 2.97 2.91%
TEVA Teva Pharmaceutical  38.29 15.6 2.45 2.1 1.46 3.82%
EXPD Expeditors Int'l of WA 35.76 22.35 1.6 1.5 3.62 4.56%
CTXS Citrix Systems, Inc. 59.21 32.34 1.83 - 3.56 4.67%
MRVL Marvell Technology 7.4 12.67 0.58 3.2 0.88 4.96%
NUAN Nuance Communications 20.35 77.38 0.26 - 2.4 5.28%
KLAC KLA-Tencor Corporation 44.33 10.78 4.11 3.6 2.18 5.35%
APOL Apollo Group Inc. 19.51 5.61 3.48 - 2.37 5.69%
ATVI Activision Blizzard, Inc. 11.05 14.26 0.78 1.7 1.08 5.75%
MU Micron Technology Inc. 5.47 - -1.04 - 0.72 6.01%
FFIV F5 Networks, Inc. 86.64 25.11 3.45 - 5.19 6.87%
WCRX Warner Chilcott plc 11.98 8.2 1.46 4.2 -4.48 6.87%
CHKP Check Point Software 43.67 15.21 2.87 - 2.71 7.56%
DLTR Dollar Tree, Inc. 38.82 15.6 2.49 - 5.9 7.71%
GRMN Garmin Ltd. 37.18 12.57 2.96 4.8 2.14 8.05%
XLNX Xilinx Inc. 32.56 17.6 1.85 2.7 3.12 8.53%
FAST Fastenal Company 41 29.71 1.38 2.1 7.29 9.01%
MSFT Microsoft Corporation 26.52 14.34 1.85 3.5 3.26 9.14%

Watch List Summary

In the November 2, 2012 Watch List summary we pointed out NetApp (NTAP) as a viable investment candidate.  In the two weeks since, NTAP has managed to rise +9% while the Nasdaq 100 and Apple Inc. declined –4% and –9%, respectively.  NTAP is sitting at $30.26 price and may have found some support at that level. Although we’re hopeful about the prospects of this company, we recommend putting +9% gains in two weeks into perspective and decide if selling the principle is the most prudent approach to take.

On the November 2, 2012, we discussed the prospects for Dell (DELL).  At the time we felt that the stock had a high probability of going back to the $8 level.  On Friday November 16, 2012, we believe that DELL has fallen through the last line of technical defense against going to the $8 level.  We believe that on a short-term basis DELL will rise on a possible market reaction.  However, the intermediate-term seems to indicate that DELL will go to $8 before any “true” indication of prospects is revealed, unless the company gets acquired which seems possible.  Dell would be one of the best acquistion target of any computer manufacturer since Lenovo bought the personal computer division from IBM.

Apple Inc (AAPL) and short-term Dow Theory analysis

As described in our last Nasdaq 100 Watch List dated November 2, 2012, Apple Inc. (AAPL) is the stock to watch.  Right now, there are many who are suggesting that the bottom is in for AAPL.  For various reasons, we believe that the verdict has not been delivered on this stock.  Especially since AAPL managed to close below the May 2012 low, a previous technical low point for the stock.  Regardless of our view on the matter, we’d like to see what Dow Theory has to say about the upside prospects from the current price.  The chart below outlines the four upside targets for AAPL.

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Starting with the first upside target is the $572.19 level.  This is an easily attainable level for the stock and would equal an +8.44% gain from the closing price of Friday November 16, 2012.  After coming off of such a dramatic decline that was started on September 17th, we should expect this as the minimum reaction of a declining trend.  There is little in the way to suggest that AAPL is clearly on the ascent when it reaches $572.19.  However, in theory, this would be the easiest money every made in AAPL stock.

The next upside target for Apple Inc. (AAPL) is $605.41.   This level is based on Dow’s 50% principle which indicates the average price paid by long-term investors and would be compelled to continue holding the stock if it rises above this level.  If AAPL can manage to rise above this level then long-term investors are likely to hold their positions in the stock, leaving speculators to push the stock higher.  However, failure to rise above the $605.41 level and falling below the $505 level will be confirmation that the trend of the stock is much lower than the $505 level.

The $638.63 price falls in line with Dow’s assertion that stocks then can retrace 1/3 to 5/8 of the previous move.  In this case, the $638 level is 2/3 of the previous decline.  Rising to such a level almost assures that the stock will rise to the previous high.  However, those wishing to take advantage of such a “guaranteed” move to the upside should be aware of the risk that any gains that are achieved can be quickly taken away.  This would be the hardest money ever made for any speculator in AAPL’s stock.

Finally, rising above the $705 level would be the only indication that the stock is going higher in a meaningful fashion.  We believe that if AAPL manages to exceed prior high then there are great opportunities of other tech companies near a new 52-week low to take advantage of the renewed faith in Apple Inc.

Akamai Is a Sell

After the market closed yesterday, Akamai (AKAM) reported that “Third quarter revenue of $345 million, up 23 percent year over year, GAAP net income of $48 million, up 14 percent year over year; or $0.27 per diluted share, up 17 percent year over year, Normalized net income* of $79 million, up 24 percent year over year; or $0.43 per diluted share, up 26 percent year over year.”  The news seemed to caught the market flat-footed as the stock had been selling off from the October 8, 2012 high of $39.60 down to the closing price of $36.11 on October 24, 2012.

Last year, on October 21, 2011, we posted our recommendation of Akamai was among the best candidates for consideration from our Nasdaq 100 Watch List.  At the time, AKAM was trading at $23.85 and we said the following of the stock:

“…we believe it is worth considering Akamai from a Dow Theory perspective for any upside potential that might remain for the company. According to Dow Theory, so far the average price paid by investors, as opposed to speculators, is $36.45. This indicates the point at which an investor, over the last year, considers to be the “fair value”. This implies that the stock, at maximum could gain nearly 52% in due time. However, taking into account Charles H. Dow’s claim that in a bear markets, investors should only expect half of what would be considered “fair value” in a bull market, we think that in the next year Akamai could rise to the $30.15 level before faltering. We have acquired share of Akamai with the expectation that the stock will decline by at least 50%, at which point we will reconsider buying additional shares.”

Dow Theory seems to have honed in on all of the technical support and resistance levels for Akamai price.  Surprisingly, AKAM’s price rose from $23.85 to $30.43 before faltering in early November 2011.  This reaction was within 1% of our estimate where we thought that the stock would have experienced some resistance within a rising trend.

At the current time, according to Dow Theory, AKAM has upside targets of:

  • $42.31
  • $46.25
  • $50.19

And downside targets of:

  • $33.13
  • $25.92
  • $18.65

However, now that Akamai has resoundingly risen above the Dow Theory fair value level of $36.45, any additional rise of the stock is a gift.  Because our tax-deferred investing (and qualified accounts) strategy  employs Charles H. Dow’s approach of “seeking fair profits,” we are recommending that holders of Akamai consider selling the principal investment in the stock if purchased based on our October 2011 recommendation and pursue alternative investment opportunities in companies that are reasonably undervalued on a relative basis.

image

Those not interested in following through with our sell recommendation can feel comfortable knowing that Akamai is a reasonable holding with a +55% margin of safety since our initial review of the stock. 

Dow Theory: Not Broken, Just Misunderstood

Barron’s attempts at Dow Theory has failed miserably…again. In the September 29, 2012 article by Jacqueline Doherty titled “Broken Dow Theory,” it is suggested that “A lagging transportation sector historically has been considered a bad omen…” and then recites the standard, sub-standard nomenclature “…less shipping means fewer goods are being produced and purchased, which means the economy is slowing and the stock market could be headed for a fall.” Doherty goes on to cite data from Bespoke Investment Group asserting that even though the Transportation index has fallen behind the market in general, it may not mean that the stock market, as represented by the S&P 500, necessarily needs to follow the same script.

Fortunately, Dow Theory is very specific about how to interpret the Dow Jones Industrial and Transportation Averages since the publication of Robert Rhea’s book The Dow Theory. Nowhere in the rules of Dow Theory is there any indication that the vacillations of the S&P 500 are remotely part of the interpretation of the theory. Especially since the S&P 500 came onto the scene over 60 years after the creation of the Dow Industrials.

Despite the fact that there are some Dow Theorists who frequently use the S&P 500 as a substitute for indications of a rising or falling market (this isn’t Dow Theory), there is little evidence that using the additional index is necessary. Alternate indexes are only necessary when and if the Dow Jones Industrial and Transportation Averages no longer exist.

While the prevailing opinion is that the Dow Industrials isn’t a relevant index reflective of the market as a whole, a distinction should be made between a “lagging” index and a “divergent” index. A lagging index is one which is going in the same direction as the other but is not increasing/decreasing at the same rate. A divergence is when one index goes up while the other index is going down. The chart below shows two failures and one divergence between the Industrials and Transports.

image_thumb[8]

When one index cannot make new highs in accordance with the other index, it should be considered a significant failure and a warning sign. A perfect example is when the Transportation Index made a new high in 2008 and the Industrial Index could not follow through. The subsequent decline in both indexes was staggering.

In situations where there has been a divergence between the Dow Industrials and Transports, it is the Transports that typically leads the divergence to the upside or downside, meaning that the Transports will provide a clue as to the potential market direction in spite of the action of the Dow Industrials. Although historically this has been the case, Barron’s has unwittingly legitimized the view that the spread between the Dow Industrials and Dow Transports is some form of Dow Theory. In no way is this the case. In fact, in the period from 1896 to 1984, the Transports have exceeded the Industrials, on a percentage basis, 15 out of 25 Dow Theory bull and bear market moves.

Year DJI beat by DJT beat by Year DJI lost by DJT lost by
1896 33.50%   1899 -13.30%  
1900   51.00% 1902 -6.40%  
1903 88.60%   1906 -7.30%  
1907 24.50%   1909 -5.30%  
1910 10.10%   1912 -13.80%  
1914 78.70%   1916 -3.10%  
1917 64.80%   1919 -26.00%  
1921 18.40%   1922   -2.30%
1923 192.30%   1929   -3.80%
1932   15.60% 1937   -21.40%
1938   20.60% 1938   -6.40%
1939   20.30% 1939 -5.30%  
1942   64.40% 1946   -16.50%
1947   39.40% 1948   -20.50%
1949   92.50% 1953   -6.50%
1953 3.80%   1956   -27.80%
1957   819.90% 1959   -12.40%
1960 5.80%   1961 -2.90%  
1962   48.80% 1966   -7.00%
1966   19.20% 1968   -22.30%
1970   82.40% 1972   -14.50%
1974   10.00% 1976 -13.10%  
1978   86.50% 1981   -10.60%
1982   44.00% 1983   -9.70%
1984   177.80% 1984   -31.00%
           
  DJI DJT   DJI DJT
Total 520.50% 1592.40% Average: -9.65% -14.18%

The table above reflects the percentage by which the respective indexes exceeded the other from either the bull market low or the bear market top. In the timeframe indicated above, the Transports have routinely exceeded the Industrials to the upside by nearly three times. The same is true for Dow Theory bear market moves where the Transports have excessive downside moves as compared to the Dow Jones Industrial average by nearly 50%.

The pattern of excessive gains and losses in the Transports versus the Industrials has remained the case since 1984. As an example, at the peak in 2007, the Dow Industrials declined –54% while the Transports declined –60%. On the rise from the 2009 bottom, the Industrials and Transports registered gains of +110% and +162% based on their respective peaks. Excessive gains and losses, by the Transports above that of the Industrials, demonstrates that the Transports usually act as a leading indicator of market direction.

It should be noted that before the work of Wall Street Journal editor William Peter Hamilton and author Robert Rhea on the topic of Dow Theory, Charles H. Dow (co-founder of the Wall Street Journal) created and analyzed the Rail Index (now Transports) without the existence of the Dow Industrials for 12 years, from 1884 to 1896, for indications of market direction. Those 12 years are the basis of what Dow was able to formulate his observations on the market.

Unfortunately, the Barron’s article goes on to quote a CIO who states that the “…Nasdaq 100 and S&P 500 are better leading indicators than the transports.” Based on the available data, the Nasdaq 100 has not been able to exceed the all-time high set in January 2000. Additionally, the S&P 500 has not managed to exceed the all-time high set in October 2007. In the bull market run since the 2009 low, the Transportation Average has managed to exceed its all-time high unlike the Nasdaq 100 and S&P 500.

Finally, Barron’s quotes data from Bespoke which reviews, “…periods when the S&P 500 exceeded the transport index by 10 percentage points over a 50-day trading period. Going back to 1928, the S&P 500 gained 1% in the subsequent six months, not awful although below the average six-month gain of 3.5%.” Using a “50-day trading period” to arrive a conclusion about the next six months is inadequate in making even a cyclical determination of a bull or bear market based on Dow Theory, let alone a secular indication. Dow Theory is about the primary trend of the market which tends to last from 3-4 1/2 years at a time.

In order to make a “complete” secular and cyclical analysis based on Dow Theory, interpretation should begin at the prior dual Industrial and Transport peaks in 2007/2008, at minimum. Until there is a dual Industrial and Transport new high, cyclical new highs in one index or the other would be a bear market reaction as indicated in our August 9, 2011 note titled “Bear Market Rally Targets.” Our indication that a bear market rally was about to take place was with 2% of the October 3, 2011 low, giving full opportunity to seek out new investment opportunities before the bear market rally to the current peak in the Industrials. The current divergence of the two indexes is confirmation of the fact that we’re still in a bear market rally until the prior 2009-2011/2012 highs are exceeded for a cyclical bull market and all-time highs for a new secular bull market.

Until 1956, Barron’swould include Dow Theory analysis in the Market Laboratory section every week. Since 1956, Dow Theory would show up only in feature articles from experts on the topic. Now, it seems that anyone making mention of either the Dow Industrials or Dow Transports can suffice as knowledgeable on the topic of Dow Theory.

Naturally, there are many critics who adamantly speak out against Dow Theory, which is surprising since Charles H. Dow’s work of creating the Wall Street Journalalong with his theories of the stock market are the foundation of both fundamental and technical analysis in the United States. However, the critics, even without knowing the nuances of Dow Theory, are justified in their claims especially when the “analysis” is so incomplete and inaccurate.

If the goal is to do away with Dow Theory and eliminate the indexes then that is fine. However, if the goal is to actually interpret the theory in some mediocre fashion then it should be done by someone who has actually studied the topic extensively. Barron’s, a place where William Peter Hamilton and many other great Dow Theorists were prominently featured, is doing a disservice by connecting unrelated and disparate themes and suggesting that somehow the theory is “broken.”

Dow Theory: Downside Prospects

We have indicated in our August 2, 2011 posting (found here) the fact that we are now in a bear market.  According to Dow Theory, the primary trend remains in place until the opposite indication has been signaled.  This is best described by Richard Russell in the following remark:

…the Dow Theorist has learned that the last trend should be considered to remain in effect until the contrary has been proved”[1].

We believe that there has not been a reversal of this bear market indication as outlined in our August 7, 2012 Dow Theory analysis (found here).

Despite getting a bear market signal only days earlier, on August 9, 2011 we indicated that a bear market rally (found here) was likely to take place.  Our work on the topic of Dow Theory at that time indicated that there was upside potential to go as far as the prior highs (12,807.51).  From the August 9th low, the Dow Industrials rose as high as 13,338.70, or +23.38%.

From our experience on the topic, bear markets usually connote declines of -30% or more.  However, the bear market that we’ve experienced so far can be characterized from a slight dip to a nice market run to the upside.  While the Dow Jones Industrial Average and the Dow Jones Transportation Average have diverged overall, there has been nothing that we’ve seen since August 2, 2011 to make a person feel like any confidence in the indication.  After all, it has been over a year since the signal and no real fireworks.  Was it really worth reducing market exposure for a non-event?

Since this bull market move began on March 9, 2009, there have been sizable declines of -14% or more in 2010 and 2011 before the stock market continued higher.  The best we can do at this point is assume that 2012 is due for a correction in line with the two previous years and see what the downside prospects might be.

period of decline Dow Industrials % change
April 26, 2010-July 2, 2010 -14.60%
May 2, 2011-October 3, 2011 -19.19%
May 1, 2012-???? -2.09%
   
   
period of decline Dow Transports % change
May 3, 2010-July 6, 2010 -18.72%
July 7, 2011-October 3, 2011 -28.11%
March 15, 2012-???? -6.39%

Because a bear market decline of -30% or more has not taken place, the best we can do is assume that a similar decline to 2010 and 2011 is the most likely outcome…for now.  The previous declines, within the context of a bull market, have averaged –16.90% for the Dow Industrials and –23.42% for the Dow Transports. 

If the Industrials were to decline from the current level by –16.90% it would fall to 11,035.12.  If the Transports were to decline from the current level by –23.42% it would fall to 4,096.84.

As described in our Dow Theory analysis from August 7, 2012 (found here), there are two overhanging non-confirmations of a bull market.  This means that the overall trend of the Industrials and Transports should eventually be down.  In our negative bias against an new bull market, particular emphasis is weighted against the Transportation Index which has been falling while the Industrial Index has been rising.

However, the last week of August has provide the Dow Industrial Average with what we consider a double-top.  Although not the most classic double top, it is still a double top. 

image

Double tops and double bottoms were indicated to be very important formations according to Charles H. Dow.  Alternatively, William Peter Hamilton and Robert Rhea arrived at the conclusion that such formations bear little importance when considering the price movement of the indexes.

From our own work on the topic of double tops and double bottoms, we have found that Dow was right about the importance of such a price characteristics and have been able to prove, with significant evidence throughout the history of the Dow indexes, that double tops and double bottoms are critical indicators for determining market direction when applying Dow Theory. 

In this case, a double tops mean that the direction for the stock market is down.  Since the bear market signal, based on Dow Theory, hasn’t resulted in a decline of over -30% for either the Transports or Industrials, were proposing that at the very minimum a decline of 13%–15% should be expected.

[1] Russell, Richard. Richard Russell’s Dow Theory Letters. Issue 166. December 27, 1961. page 1.

Dow Theory Update

On May 19, 2012, we said that the bear market rally had ended (found here).  In our view, we believed that the Dow Jones Jones Industrial Average would not exceed the high of 13,279.32 set on May 1, 2012.  The most recent run of the Dow Industrials is causing us to wonder if our assessment was correct.

Despite our concern that the Dow Industrials will increase above 13,279.32, we do need to point out  two technical non-confirmations of the market that have been established so far.  First is the secular (long-term) level of the market.  Ordinarily, the secular (long-term) trend of the market would be bullish when and if both the Industrials and Transports rise above their respective 2007 to 2012 peaks.

As can be seen in the chart below, the horizontal black lines shows that the Transportation Index managed to rise above the prior high of 2007/2008.  At the same time, the Dow Jones Industrial Average did not come as close to the prior highs.  This lack of confirmation suggests that we are still in a secular (long-term) bear market.

image

At the same time, on a cyclical basis (short-term), as indicated by the green lines above, the Dow Jones Industrial Average and Transportation Average have gone their separate ways.  The Dow Jones Industrial Average trending higher while the Dow Jones Transportation Average has trended lower.

So far, all indications are that we’re in a cyclical and secular bear market.  Since our bear market indication of August 2, 2011 (found here), we have not received any indication to the contrary.  However, if we’re completely wrong about the bearish direction of the market, a Dow Theory bull market indication on a cyclical basis (short-term) would occur if the Dow Industrials and Transports were to increase above 13,279.32 and 5,627.85, respectively.  Additionally, a bull market indication on a secular basis (long-term) would occur when the Dow Industrials and Transports exceed their respective highs in the period from 2007 to 2012.

Despite our concern for the bear market that we are in, we continue to pursue the policy of accumulating stocks that appear reasonably undervalued which is in accordance with Charles H. Dow’s emphasis on values at a reasonable prices. Our most recent purchases of Carbo Ceramics (CRR) and Expeditors International of Washington (EXPD) brings our partnership portfolio to 57.78% in stocks and 42.22% in cash.