Category Archives: Dow Theory

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.

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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.

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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. 

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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.

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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.

Dow Theory: 1910-1913

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Bull market indication (A): According to the Edwards and Magee book Technical Analysis of Stock Trends, the Dow Theory bull market began on October 10, 1910 when the Dow Industrials and Transports exceeded the August 17, 1910 resistance levels of 81.41 and 115.47, respectively.  The NLO team believes that the bull market began at point (C) when the Dow Jones Industrial Average and Transportation Average exceeded the July 22, 1910 resistance levels of 77.78 and 110.51, respectively.  From the point (C) of the bull signal to the respective market tops, the DJI gained +10.61% and the DJT gained +11.98%.

We also believe that after a bear market signal was issued at point (D) on August 2, 1911, a new bull market indication was issued at point (E), on November 6, 1911, when the Dow Jones Industrial Average closed at 79, above the previous resistance level of 78.34 established on October 16,1911.  The Transportation Index had already gone above the previous resistance level of 114.13 set on October 20, 1911 by closing at 114.46 on October 31, 1911. From the point (E) of the bull signal to the respective market tops, the DJI gained +19.13% and the DJT gained +6.01%.

Bear market indication (B): According to Edwards and Magee, the bear market began on January 14, 1913.  At the time, the Dow Jones Industrial Average was at 84.96 while the Transportation Average was at 115.01. Edwards and McGee never indicated that in between October 10, 1910 and January 14, 1913 there are any other bull and bear signals according to Dow Theory.

However, in our view, as we mentioned above, we believe that a bear market indication was given on August 2, 1911 point (D) when the DJI and DJT were at 84.80 and 120.71, respectively.   The Industrials and Transports fell -13.98% and -9.03% from the August 2, 1911 levels.

After getting a second bull market indication at point (E), a second bear market indication was triggered on November 4, 1912 point (F) when the Dow Jones Industrial Average declined below 90.38 on September 11, 1912.  The Transportation Average had already given the bearish indication on October 25, 1912 by falling below 120.44.  From point (F) to the June 11, 1913 low, the Dow Jones Industrial Average declined –20.21% while the Dow Jones Transportation Average declined –16.55%.

Market Outlook: Mixed Signals

On February 7, 2012, we wrote an article on the topic of gold titled “Gold Stock Indicator Points Down” (found here).  In that article, the very last sentence said the following:

“based on the current trajectory, we have May/June 2012 as our tentative reversal period.”

Well, the month of May has passed and we’ve seen an amazing plunge in gold stocks since the posting of our February 7th article, as reflected in the chart below:

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Since February 7, 2012, the XAU gold stock index declined -28.95% to the May 15th low.  As we had anticipated, the “May/June” bottom was reached, for now. Ordinarily, this would be the time to buy gold stocks, especially those that pay a dividend.  However, in our May 27th transaction review of NUGT (found here), we said that, based on our Gold Stock Indicator, there would be a second opportunity to buy gold stocks at a considerable value.

The recovery in the XAU index has been even more spectacular than the plunge.  Historically, such rapid increases in a stock or index would require a decline of at least -50% of the most recent rise, even if the trend is still higher.  Therefore, based on the most recent price of 168.71 in the XAU index, there should be a decline to the 154.56 level or half of whichever the most recent peak might be.  We’d consider buying dividend paying gold stocks at half of the highest point achieved or lower.  (Please, if you have any questions about this paragraph we’d be more than glad to explain further if we were not clear in any way.)

For now, the direction for gold stocks is up based on our Gold Stock Indicator, until proven otherwise.  However, at the same time the Gold Stock Indicator is pointing up, we have a Dow Theory bear market indication as outlined in our May 19th article (found here) suggesting that stocks in general are supposed to decline.  Our vast amount of research on the topic suggests that if the general stock market were to have a decline of 10%-15% or more, then gold stocks would decline by a greater percentage.  As an example, in 2008, when the general stock market declined –37% as reflected in the S&P 500 (full year decline), the XAU gold stock index declined -66% within the period from March 2008 to October 2008.

We don’t know which indication will take precedence.  Therefore, we are opting for the most conservative stance possible.  We’re waiting for the stock market to confirm the Dow Theory bear market indication or quickly come up with a bull market indication.  We’re holding out for the possibility that gold stocks will provide the second opportunity to buy as has been indicated in our May 27th transaction review.

Questions or thoughts?  Let us know, we’ll do our best to provided a thoughtful response.

Dow Jones Industrial Average: Where To Now?

Dow Theory Review

  • On August 2, 2011 (article here), we said that a new bear market had begun.
  • On August 9, 2011 (article here), we announced that, based on the closing price of August 8, 2011, a bear market rally would ensue (stock prices would rise.)  That call was 2 months ahead of the ultimate market bottom set in October 2011 and off the actual low by 1.43%.
  • On March 16, 2012 (article here), we warned about the lack of participation of most stocks in the rise of the stock market from the 2009 low.  Additionally, we cited the divergence between the Dow Jones Industrial Average and Dow Jones Transportation Average as confirmation that we were still in a bear market.  This was less than 1% from the actual top in the market.
  • On May 19, 2012 (article here), we pronounced that the bear market rally had ended.  This call came 7.41% below the actual peak in the market on May 1, 2012.

Charting a Path for the Dow

Now comes the challenge of determining the downside targets for the Dow Jones Industrial Average.  To accomplish this task, we’ve gone back to the secular bear markets of 1906-1924 and 1966-1982 for some insight as to what might occur going forward.  It is important to understand that the signature of a secular bear market is that it will not increase very much above the initial peak and declines significantly below the initial peak multiple times.

In the chart below, we have the price action of the Dow Jones Industrial Average from 1906 to 1924.

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In the chart below, we have the price action of the Dow Jones Industrial Average from 1966 to 1982.

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There is considerable debate about where the peak of the current secular bear market began.  Although we believe that the secular trend began at the 2007 peak,  we’re being conservative by considering that the most recent secular bear market began at the 2000 peak, as represented in the chart below.

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Beneath each trough is the number corresponding to the major declines within the secular bear market. In each chart there are at least three major market declines while the peaks remain in close proximity to the original market peak.

It is our view that the first decline of the Dow Jones Industrial Average in the secular bear market trend later becomes a minimum downside target.  In the current market, we believe that the Dow Jones Industrial Average will revisit the 8,200 level.  If the Industrials were to revisit the 8,200 level, the total decline would be approximately -32% from the closing price of June 1, 2012.

NetApp: Dow Theory Gets It Right

On May 24, 2012, NetApp (NTAP) was hammered down –12.29% after it was announced that the company forecasted lower earnings.  The decline of NetApp comes as no surprise to us as we ran our analysis of the company in our January 20, 2012 Nasdaq 100 Watch List (found here).  In our Dow Theory analysis of NTAP, we said the following:

“According to Dow Theory, the current downside targets are $28.02, $22.52 and $17.02. Based on the current price of $36.85, NTAP could fall by 53% in the worst case scenario. According to Dow Theory, NTAP has upside targets of $44.52, $50.02 and $55.52.

The Punchline: After a 39% decline in price, NetApp (NTAP) is a prime candidate for a two transaction purchase. The first purchase should take place starting at $30. The second purchase should take place around $23.47. Based on the market capitalization, NTAP may actually be a buyout candidate.”

Dow Theory set accurate parameters for the upside and downside targets.  After our January 20, 2012 posting, NTAP rose as high as $46.45 and has retrenched as low as the current closing price of $28.82.  Although we said that NTAP is a buy at prices below $30, as indicated above, our macro view on the markets are negative at the present time as found in our May 19, 2012 (found here) Dow Theory analysis.

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It appears that NTAP will easily achieve the Dow Theory downside target of $22.52 and may achieve a rebound at the $20 level.  However, because Dow Theory suggests that the overall market will decline further, we believe that the first purchase of NTAP could reasonably take place at $22.52 or below, instead of $30 or below.

We will reassess NTAP in terms of the general market when, and if, the price declines to the $22.52 price.

Dow Theory

Our posting from May 12, 2012 should have said it all, we said the following:

“We believe that the break below 12,715 on the Industrials and 5,047 on the Transports would lead to a more bearish move for the market, at least for the intermediate term.”

On May 14, 2012, the Dow Jones Industrial Index fell to the closing low of 12,695.35. This was below the 12,715 level that we believed was a critical support level for the Industrial Index.

On May 17, 2012, the Dow Jones Transportation Index fell to the closing low of 4,938.18.  On May 18, 2012, the Transports fell to the closing low of 4,873.76.  This was significant in that it was below both the 5,047 level and below the 200-day moving average.

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As of Friday May 18, 2012, the bear market rally, which began on August 9, 2011 (found here), is over. Now it is a simple matter of how much of a decline that we have in store.  The following are the downside targets for the Dow Jones Industrial Average (% decline based on 5/18/2012 close):

  • 11,728.46 at –5.18%
  • 11,192.80 at –9.51%
  • 10,362.26 at –16.23%

We will reassess the downside moves when and if the above targets are met.

Dow Theory Update

The S&P 500 fell -1% for the week on fears of another European zone collapse. Topping it off, JP Morgan (JPM) announced a $2 billion trading loss for the quarter which took the markets by surprise. One may wonder where the market will head in the coming weeks. Going back to our post on March 15 on Dow Theory, we suggested caution should be the operative word. Since then, the S&P500 had declined -3%.

When the Dow Jones Industrial Average broke above the 13,000 level in March, the Dow Jones Transportation Average failed to exceed its February high of 5,368. Divergence between the Industrials and Tranports is continued cause for concern. The transports appear to be trading in a line formation. Similarly, the Industrials have traded in a narrow range between 13,300 and 12,700.

We believe that the break below 12,715 on the Industrials and 5,047 on the Transports (red lines in the chart below) would lead to a more bearish move for the market, at least for the intermediate term.  All of this is within the context of the bear market rally as indicated in our August 9, 2011 article (found here).

INDU

TRAN

Is a Recession Coming?

Review

On August 23, 2009, using Dow Theory and the Industrial Production Index [IPI], we predicted that the National Bureau of Economic Research (NBER) was going to say that the recession ended in June 2009 (article here).  We specifically said the following:

“Implicit in my discussion of the IPI [Industrial Production Index] 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.”

As has been the case historically, the announcement that the recession had ended came 1-year and 3 months after the fact (NBER announcement found here.)  Additionally, few have been satisfied with the definition of a recovery especially if it means that job growth and income increases have not been exceptional.

Now we are faced with what we believe could be the defining moment for a sustained stock market and economic decline worthy of being deemed (by NBER) a recession.  The factors that go into this assessment are based on our interpretation of Dow Theory and the vacillations of the Industrial Production Index.

Dow Theory

Starting with Dow Theory, we have the following established indications:

  • On August 2, 2011, Dow Theory indicated that we were in the initial stages of a cyclical bear market (article here).  At the time, the Dow Jones Industrial Average (DIA) and the Dow Jones Transportation Average (IYT) fell below their respective June and March 2011 lows.
  • On August 9, 2011, we indicated that a bottom had been reached and that a bear market rally to prior highs was due, within the context of a cyclical bear market (article here).
  • On March 16, 2012, we demonstrated that the divergence between the Dow Jones Industrial Average and the Dow Jones Transportation Average was confirmation that we’re in a Dow Theory bear market rather than a renewed bull market (article here).

Generally speaking, Dow Theory acts as a leading indicator of the direction of the overall economy, with the Industrial Production Index following behind as confirmation.  In this case, this is the first month that the Industrial Production Index (IPI) has declined after the Dow Theory bear market indication of August 2, 2011.

Industrial Production Index

Historically, the Industrial Production Index has “averaged” a decline of 1.44 consecutive months in periods of an economic growth period.  This suggests that if the Industrial Production Index declines for two full months in a row, it would be enough to give us the all clear as to whether we can consider the economy as having reverted back into a recession after the rise from the June 2009 bottom.  This interpretation relies on Dow Theory also having a bear market indication.  In order for this to be the case, The Dow Industrials and Dow Transports would need to remain below their respective 2012/2011 peaks.

Month IPI data
August 2011 94.1845
September 2011 94.3800
October 2011 94.9389
November 2011 95.0939
December 2011 95.9095
January 2012 96.5705
February 2012 96.5731
March 2012 96.5685
Source: St. Louis Fed

What would the Market Impact Be?

So far, we expect that the recessionary period would have at least four consecutive months of declines in the Industrial Production Index (IPI) and a total of at least  7 non-consecutive months of declines within the period considered a recession.  This would be on par with the recession from July 1990 to March 1991.  At the time of the 1990 to 1991 recession, the S&P 500 (SPY) declined -19.61% and the Nasdaq Composite Index declined –29.90%.

However, The stock market typically leads the call of a recession by topping out first.  this suggests that potentially, the April 2, 2012 high for the Dow Industrials was the top and we're now in a declining trend at least until August/September 2012 to 10,611.59.

Again, our preliminary prediction is that if we see a second month of declines in the Industrial Production Index while the Dow Theory bear market indication is in place, we’ll have what will be considered a recession by the NBER which would be announced from 9 months to a year after the fact.

As a sidebar to the discussion of the possibility of a recession, the long-term gold stock positions that we've recently recommended which includes Agnico-Eagle (AEM),  Gold Fields Ltd. (GFI) and Newmont Mining (NEM) will require reduced exposure or sold off since gold and silver stocks tend to perform worse than the general stock market during a recession.

Note: Industrial Production Index data is subject to constant revisions by the Federal Reserve Bank.  We hope to reassess the Industrial Production Index based on the most updated information that is provided by the Federal Reserve.

Nasdaq 100 Watch List: March 16, 2012

Below are the Nasdaq 100 companies that are within 20% of their respective 52-week lows. This Nasdaq 100 Watch List is strictly for the purpose of researching whether or not the companies have viable business models or are about to go out of business. These companies are deemed highly speculative unless otherwise noted.

Symbol Name Price P/E EPS Yield Price/Book payout % from Low
CHRW C.H. Robinson Worldwide 65.67 25.06 2.62 2.00 8.55 50.38% 5.41%
VOD Vodafone Group Plc 26.41 12.28 2.15 3.60 1.02 44.19% 8.64%
EA Electronic Arts Inc. 17.46 0 -0.52 0.00 2.45 0.00% 8.79%
CTRP Ctrip.com Int'l 24.68 22.09 1.12 0.00 3.03 0.00% 12.08%
APOL Apollo Group 42.59 12.08 3.53 0.00 4.07 0.00% 14.86%
FSLR First Solar 29.08 0 -0.46 0.00 0.66 0.00% 14.99%
AMZN Amazon.com 185.05 135.07 1.37 0.00 10.82 0.00% 15.07%
RIMM Research In Motion 14.38 3.39 4.25 0.00 0.68 0.00% 15.50%
VMED Virgin Media Inc. 24.18 65.18 0.37 0.70 7 43.24% 17.84%
SRCL Stericycle, Inc. 86.88 32.3 2.69 0.00 6.11 0.00% 18.93%
DTV DIRECTV 47.47 13.68 3.47 0.00 -10.53 0.00% 19.21%
EXPD Expeditors Int'l of Wash 45.81 25.59 1.79 1.10 4.71 27.93% 19.76%

Watch List Summary

A company that we’re considering buying is C.H. Robinson Worldwide (CHRW), the first company on our list.  The primary consideration that we have is always the downside risk.  We almost ignore the upside targets and projections in order to come up with an idea on the best ways to avoid loss.

The following are two perspectives on the way to view the potential downside risk of buying CHRW. First, according to Dow Theory, CHRW has three significant downside targets that should be considered carefully. The three downside targets are as follows:

  • $60.34 (fair value)
  • $52.91
  • $38.06

The way we approach the Dow Theory downside targets is to buy CHRW if it falls to $60.34 (fair value according to Dow Theory). However, we prepare ourselves for the worst case scenario by expecting that CHRW will decline to the $38.06 level, the low for 2009. With this assumption, we ensure that our initial purchase does not include 100% of what we'd normally invest. Instead, we only invest 30%, 50% or 65% of the amount that we'd ordinarily invest. The remainder of funds is set aside for the possibility that the stock declines. Naturally the greater the amount invested initially, the greater the loss or gain if the stock declines or rises.

The second way to view CHRW's downside risk is strictly from the "technical" patterns based on a chart from the last 5 years.

3-16-2012

From a "technical" standpoint, there are significant support levels at $63.50, $55 and $38. These technical levels are not very different from Dow Theory even though the technical levels based on the chart above are strictly based on the visual cues. We specifically chose the last 5 years because Charles H. Dow has said that best way to gauge a company's future prospects is usually through careful consideration of the period when earnings, book value, price and other fundamental attributes are at their worst. For us, the inclusion of 2007 to 2009 is the best reflection of the worst that has been experienced recently.  With either approach to reviewing the downside risk of a stock, the purpose is ensure that you do not get caught off guard at the prospect of a major price decline.

Watch List Performance Review

In our ongoing review of the Nasdaq 100 Watch List, we have taken the topic 5 stocks from our March 6, 2011 Nasdaq 100 Watch List.   The top 5 companies from the watch list are provided below with the closing price from March 7, 2011 to March 6, 2012.

Symbol Company 2011 2012 % Change
CSCO Cisco Systems, Inc. $18.40 $20.03 8.86%
CEPH Cephalon, Inc. $56.17 $81.49 45.08%
AMGN Amgen Inc. $52.32 $67.38 28.78%
TEVA Teva Pharmaceutical Industries  $50.32 $43.08 -14.39%
ATVI Activision Blizzard, Inc $11.27 $12.65 12.24%
Average 16.12%
NDX Nasdaq 100 $2,328.07 $2,712.78 16.52%

3-6-2011 Top 5

Our primary goal at the New Low Observer is to achieve 10% gains within the span of a year inside of our tax deferred accounts.  In the case of AMGN, CEPH and ATVI our goal of 10% within a year was accomplished within the first four months.  CSCO was the last 10% gain that arrived at the end of the 1-year period.  Teva Pharmaceutical (TEVA) severely underperformed for the remainder of the 1-year period.  CEPH did not last very long since it was acquired by none other than Teva Pharmaceutical.  Cephalon was acquired by TEVA within two months of being on our watch list.

Our specific recommendation of Cephalon at $58.99 on February 15, 2011 and the subsequent acquisition explains why we’re drawn to companies at a new low.

Broader Market and Dow Theory Suggest Proceeding with Caution

As the Dow Jones Industrial Average and S&P 500 exceed the highs set in 2011, there is an alarming coincidence with 1972, just before the Dow Industrial’s -44% decline, that we’d like to bring to your attention.  To set the stage, we must first point out an important factor about the Dow Industrials and S&P 500 that contributes to their ability to reach new highs.

First, the Dow Jones Industrial Average is what is considered to be a price-weighted index.  According to Investopdia.com, a price weighted-index is:

“A stock index in which each stock influences the index in proportion to its price per share. The value of the index is generated by adding the prices of each of the stocks in the index and dividing them by the total number of stocks. Stocks with a higher price will be given more weight and, therefore, will have a greater influence over the performance of the index.” (read more here)

Next is the S&P 500.  The S&P 500 is a capitalization-weighted index.  Again, referring back to Investopedia.com, a market-cap weighted index is:

“A type of market index whose individual components are weighted according to their market capitalization, so that larger components carry a larger percentage weighting. The value of a capitalization-weighted index can be computed by adding up the collective market capitalizations of its members and dividing it by the number of securities in the index.” (read more here)

Each of these indexes are biased in the way they reflect the overall market movement.  In the case of the Dow Jones Industrial Average, it is biased towards the highest priced members while the S&P 500 is tilted to the stocks that are similarly expensive, on a market-cap basis.  In order to get a true sense of how all of the stocks are faring, rather than a select few that have been favored by investors, it is best to track a broadly based “equal-weighted” stock index.  According to Investopedia.com, an equal-weighted stock index  is:

“A type of weighting that gives the same weight, or importance, to each stock in a portfolio or index fund. The smallest companies are given equal weight to the largest companies in an equal-weight index fund or portfolio. This allows all of the companies to be considered on an even playing field.” (read more here)

For the most part, an equal-weighted index reflects how all stocks have fared in a bull or bear market.  This is important because it allows for greater insight into where we are and potentially where we might be going.  One equal weighted index of over 1,700 companies that has been around since 1962 is the Value Line Geometric Index (found here).  In the chart below, we have compared the market action of the Value Line Geometric Index over a ten year period from 1962-1972 and 2002-2012.

Value Line Geometric

What should stand out the most between both charts is the fact that, according to the Value Line Geometric Index, while the general indexes like the S&P 500 and Dow Jones Industrial Average are making new highs, the majority of stocks have not participated in the rise.  In addition to not exceeding the peaks of 1968-1969 and 2007, the inability to exceed the 2011 highs is an indication of significant resistance as was experienced in 1971 and 1972 peaks.

Adding to our concern about the lack of participation by the broader stock market is the divergence between the Dow Jones Transportation Average and the Dow Jones Industrial Average since February 2012 (found here).  This divergence can also be found in the chart below in the period from April 6, 1972 to January 5, 1973 between the Transports and Industrials.  The declines that followed the divergence and peak of ‘72-‘73 were -59% and –44% for the Transports and Industrials, respectively.

DT '72

Until the Dow Theory divergence is resolved and the Value Line Geometric Index make new highs above the 2011 and 2007 peaks, we’re concerned that the stock market is skating on thin ice.

Dow Theory Update

It appears that Dow Theory is not understood, by even the best in the industry.  In an article titled “The Meaning of the Transports’ Weakness,” Mark Hulbert surveyed some of the industry’s best Dow Theorists for a clue as to what the market was expected to do next. What stands out in this article is the following remark:

“Frustratingly, not all Dow Theorists agree on an answer. In fact, two of the three monitored by the Hulbert Financial Digest — Jack Schannep of TheDowtheory.com and Richard Moroney of Dow Theory Forecasts — think the appropriate point of comparison is not last summer but late October. And because, near the end of December, the Dow averages rose above their late-October highs, both Schannep and Moroney believe that the Dow Theory is solidly in the bullish camp — notwithstanding where the Dow transports might be relative to their July high.”

Within this commentary is a revealing explanation as to the reason why we believe that Schannep and Moroney got it wrong, thereby issuing a bear market indication in August 2011 and a bull market indication in late December 2011.  In order to understand this, we must first point out a diagram of how Dow Theory reversals typically occur.

Plotting of Primary Reversal

Courtesy of Richard Russell’s Dow Theory Letters (www.dowtheoryletters.com), Figure 1a and Figure 1b show how the Industrials and Transports need to retest prior lows established at point A.  This retesting of the prior low would come after a medium-term rise at point B.  Once the market rests the prior low, the market would then need to exceed the medium-term high of point B.

With the diagram above, we can now see how Schannep and Moroney could have considered that a new bull market was in the making.  Once the market exceeded what they believed to be the POINT B in figure 1a and 1b, it then appeared to be a new bull market.  Unfortunately, while the Dow Industrials appeared to follow the script in Figure 1a, the Transports were far behind in providing a similar pattern of retesting the previous low.  This error led to an incorrect assessment of a new bull market.

Interestingly, Schannep and Moroney were inaccurate even in their call of a “bull market” using Dow Theory.  Based on the diagrams of figure 1, a new bull market should have been indicated in early October instead of late December.  In the chart below, it should be noted that the false bull market indication in October had much more to gain than the late December indication.  Worse still, only a month later, in February 2012, the Dow Transportation Average starts to diverge from the path of the Dow Jones Industrial Average.

2012 03 06 Dow Theory

The current divergence between the Industrials and Transports is a confirmation of the bear market trend.  Additionally, we expected that the Industrials and Transports are going to re-test the lows of 2011.  However, our suspicion is that both the Transports and Industrials will sink below the 2011 lows and possibly go strait to the 9,700 level on the Industrials.  The prospect remains that the bear market could potentially end if the Transports retest the lows of 2011 without falling significantly below.

As early as October 15, 2011 (article here), we indicated that the “…coming market volatility will provide great opportunities for traders and allow investors a chance to cash out of otherwise undesirable positions and take profits. Our expectation is that the Dow will go to the July 2011 highs before struggling at the May 2011 highs. Again, we’re still in a cyclical bear market until the Transports and Industrials exceed their respective 2011 highs.

We hope that our readers have benefitted from our advice to unload undesirable positions.

Best regards.

Correction of Errors on iShares Silver Trust (SLV) Interpretation

In our previous reviews of the iShares Silver Trust (SLV) (found here), we attempted to apply Dow Theory to the price movement of SLV. However, we have made an error in our analysis that has resulted in arriving at the wrong conclusion of the price potentially declining to the previous low that was established at the beginning of the bull market run on November 21, 2008 at $9.02.

 

Instead, we are revising our analysis to reflect that the price of silver may decline as low as $21.02 if it were to replicate the rise and decline from October 2001 to November 2008.This revision should provide a more qualitative view on the future prospects for both SLV and the price of silver.


As background to the error that was made, we first must explain that the iShares Silver Trust (SLV) is supposed to track the price of silver. However, SLV has only been in existence since April 2006.Our Dow Theory analysis of SLV was incorrect because we didn’t have an appropriate starting point, the previous low, to arrive at a correct downside target. The previous low occurred in 2001 which was long before SLV began trading.


This resulted in the mistaken belief that SLV should be expected to go back to the low of 2008 at $9.02. To remedy our error, we have obtained the price of silver from the last major low in the price, and re-ran our Dow Theory analysis. The chart below provides the three downside targets from the March 17, 2008 high of $20.99.


The downside targets from the peak were as follows:
In the final outcome, the price of silver fell below the third downside target of $9.68, ultimately resting at the $9.02 level before making the ascent to the recent high of $48.35.This sets the stage for our analysis of the current price action.
Our current Dow Theory analysis involves the period from the November 21, 2008 low at $9.02 to the peak of April 28, 2011 at the $48.38 level. The downside targets are as follows:
It should be noticed in the chart below that as time passes, the support levels increase which exerts greater pressure on the price to either rise substantially or breakdown.

 

Despite the revision to our numbers, our previous analysis about the expected outcome has remained accurate.Our May 5, 2011 article was on target with the claim that SLV would trade in a range before falling much further. SLV traded in a range until mid-July and ultimately fell as low as $26.16, a drop of -30.87% since that article was written.
The current indications suggest that SLV will fall as the $22.14 support level. Because silver easily fell to the third support level in the period from 2001 to 2008 (within the context of a precious metal bull market), we expect that the $21.02 is a realistic worst case scenario to watch for. We will consider buying silver and related derivatives at $22.25 and below.
We view the most recent rise from the December 2011 low as running out of steam.Therefore, the rising resistance level established at $28.70 appears to be firmly in place…for now.