The Birth Of The Mega Bull?

Includes: DIA, IWM, QQQ, SPY
by: Mike Broudy

The Last Four Years

This Bull Market has gone on, and on and on. Since 2009, every Intermediate dip has been bought, investors have been rewarded for buying the breakouts on minor moves, and a rising tide continues to lift most boats. Today marks the four-year anniversary of the ultimate bottom of the fallout from 2008 that occurred on March 6th, 2009, when the Dow traded at an intraday low of 6,469.95, and the S&P 500 traded at an intraday low of 666.79. What a coincidence that the Dow is very near, and might possibly hit, its record high exactly four years to the day later. This performance comes after a time when the entire financial system was imploding upon itself so rapidly, and our worst nightmares were being realized so quickly, that the only thing left to do was sell in a panic. This cascading series of negative events and fear created a buying opportunity the likes of which may never be seen again in our lifetimes. Four years to the day later, the effects of this panic bottom are still playing themselves out and may well last for another four years.

The fact that the Industrial Average is so near its all-time high, let alone may potentially break its record, seems to justify disbelief or astonishment. The four-year turnaround from low back to previous high seems to defy all odds - and reason. And as an active investor who stays abreast of all important market news, I can only imagine what the average American will think if, and when, the media proclaims with great fervor that the Dow has completely recovered all of its losses and now stands at an all-time high. The move comes against the appalling backdrop of the world stage that has included such acts as ponzi schemes, a real estate collapse, bailouts, multitudes of bank failures, the Greece national debt crisis, the eurozone crisis, a Libyan Civil War, and US debt ceiling brinkmanship, to name a handful. Now we face the current market threats of the day: the "fiscal cliff," the US sequester, the growing Federal Reserve balance sheet, the ongoing eurozone recession, and continual unemployment. This economy is certainly not the "Goldilocks Economy" of yore, as Mr. Larry Kudlow of CNBC was so fond of referring to the last "great" economy and Bull run (until it was apparent it was not).

So then what exactly is this market, and what does it say about the state of our economy? At four years in length, it is already twice the average length of a "normal" Bull Market, and it has not quite fit the profile of a typical Bull Market as it has advanced on declining volume. Will it continue rising with renewed vigor, turning into a Mega Bull? Or will it form a triple top and become a "Mega Disappointment" with years of sideways movement, or worse? Fortunately, the late Charles Dow left us with some insight specifically at points like these. Using the averages he created and his investment principles, we can form a general picture of the Primary market trend.

Dow Theory

Dow is given credit for the theory that bears his name; however, his principles were synthesized by his successor at the Wall Street Journal, Robert Rhea as well as William Peter Hamilton and George Schaefer. Without their work, the theory itself would not be a functional, congealed body. There are twelve tenets of Dow Theory, but for our purposes I am only going to highlight the most important aspect of the theory. The driving force behind Dow's theory is that the Industrial Average and the Transportation Average together function as a barometer for the overall economy, and they must confirm. Dow Theory states that the Transportation Average is typically a leading indicator of economic conditions because companies that are expanding require the services of transportation companies to ramp up production.

Stated another way, a higher high in one average must be confirmed by a higher high in the other. Rhea was able to extrapolate further, and state that once the averages have confirmed higher highs (or lows in a Bear Market) a Dow Theory buy signal (or sell signal in a bear market) is generated. This confirmation buy signal is a potential entry point for those who missed the first waves of a move. In order for a higher high to be considered "posted," the average in question should close above the previous high - intraday prices don't count. Given that the Industrial Average has already confirmed a higher Intermediate high, a confirmed higher all-time high close could potentially signal the start of a Mega Bull market. The all-time closing high presently stands at 14,164.63 registered on October 9th, 2007.

If you take a look at the chart below, you will see the Dow Jones Transportation Average breaking out of a year-long congestion area and sitting comfortably at record highs, potentially living up to its reputation of being the leading index. The higher all-time high was confirmed in January of this year, however, that is only half of the picture.

Monthly candle chart of the Dow Transportation Average
(Click to enlarge)

The chart below depicts the Dow Jones Industrial Average. You can see where we are. The Industrial Average has yet to confirm its higher high on a daily basis. A confirmation but subsequent failure at the highs would be a warning sign to take note of. A complete failure to confirm does not constitute a sell signal under Dow Theory, but is also a warning sign to be aware of.

Monthly candle chart of the Dow Industrial Average showing the previous high water mark.
(Click to enlarge)

At the heart of Dow Theory is its powerful simplicity. Given the relatively straightforward analysis of the theory, it has statistically performed well over time as a barometer of the Primary market trend, and could have been used to outperform buy and hold investing. Some critics argue that more averages like the Nasdaq, S&P, and Russell 2000 should be considered in addition to the two averages for additional confirmation, but this is not necessary for true Dow Theory. If you look at the Nasdaq or QQQ (Nasdaq Powershares) and Russell 2000 or IWM (Russell 2000 iShares), you can see that both are already well above their previous highs, though the Nasdaq has yet to surpass its peak made in 2000. There are plenty of great books and resources on Dow Theory for you to explore further.

The Takeaway

It may seem counter-intuitive at first that higher highs, and even a record-high in the averages, can be construed as a buy signal. As with all signals, there are numerous types of filters one can apply to increase the likelihood of success and reduce the chance of sustaining losses from a false signal. Nor do all signals need to be taken and acted upon immediately.

Despite the resiliency of the markets in general, there are still several headwinds to be aware of. The longer a trend continues, the less potential it has to continue its advance and the less attractive it becomes from a risk/reward standpoint. Another concerning factor is the possible triple top formation that would ensue if the Dow fails to successfully hurdle and maintain its previous record-high. On the positive side of the spectrum, the Transportation Average has quietly propelled itself to record-highs and that bodes well for the overall market. The Dow has reclaimed its losses largely without public involvement. An all-time high would likely heighten the public's awareness of the performance of the market, and open up the door to increased and sustained positive money flow for the next several years to come.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. I am long several quality stocks in the markets mentioned in this article, but do not own outright any of the ETF's mentioned here and have no plans to initiate positions in the ticker symbols mentioned in the next 72 hours. Information has been made available to you for education purposes only.