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As a contributor to the New Low Observer (http://www.newlowobserver.com/about-this-site), we intend to give new insights on a low risk approach to trading in dividend paying stocks for tax deferred accounts. The New Low Observer (http://www.newlowobserver.com/about-this-site) is not intended for... More
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  • Dow Theory 4 comments
    Nov 23, 2012 2:12 PM | about stocks: IYT, DIA, SPY

    In this review of Dow Theory, we're going to cover several basic concepts.

    First and foremost, we're going to discuss how long a primary bull market is expected to last. Next, we're going to explore the fiscal/economic backdrop of our last primary bear market indication on August 2, 2011 and compare it to the debate regarding the "fiscal cliff" being argued in the media. Afterwards, we going to cover Dow Theory as it currently stands with upside targets for the Industrials. Finally, we're going to review the oft ignore aspect of Dow Theory which is the Industrial Production Index and what it might be indicating now.

    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 (NYSEARCA:DIA) and Dow Transportation Averages (NYSEARCA:IYT), 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 (NYSEARCA:SPY).

    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.

    (click to enlarge)

    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:

    (click to enlarge)

    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.

    Dow Theory's Industrial Production Index Indication

    The Industrial Production Index (NYSE: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.

    (click to enlarge)

    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.

    (click to enlarge)

    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).

    (click to enlarge)

    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.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Themes: Dow Theory Stocks: IYT, DIA, SPY
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Comments (4)
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  • untrusting investor
    , contributor
    Comments (9966) | Send Message
     
    Good overview with some helpful information and commentary.
    23 Nov 2012, 02:28 PM Reply Like
  • New Low Observer
    , contributor
    Comments (2123) | Send Message
     
    Author’s reply » Greetings UI,

     

    Thank you for reading and commenting on the post.

     

    Regards.
    24 Nov 2012, 12:54 AM Reply Like
  • Freddy Hutter, TrendLines R...
    , contributor
    Comments (3738) | Send Message
     
    This is certainly your most comprehensive discussion on the theorem. I won't argue the potential of a bear stock market index, but obviously I have issues with your insinuation the apparent pause will be defined as an NBER event. Yes IP is important to such an attribution, but it is only one of five factors for declaring this a Technical Recession.

     

    Presently you are missing a declining GDP. In early 2008 this did not matter 'cuz BEA downward revised many of their GDP estimates. We appear to differ on the probability of this happening a second time.

     

    During the Great Recession the BEA revisions brought GDP down to the real-time output of the TRENDLInes Recession Indicator. By late Dec/2008, TRI was the only model warning GDP was way down in the -9.5% region whilst BEA was announcing barely negative real GDP: http://bit.ly/u7I7kK

     

    Today however, TRI gauges 2012 GDP to be 1.3% Q1, 1.7% Q2, 1.4% Q3 & 1.8% Q4. In short, whereas BEA downward-revised some quarter as much as 5% in the last event, I do not expect any major revisions this time around - they are presently tracking TRI very well.

     

    I do concede there is alotta amending going on of past economic data releases. This has played havoc with my benchmarking for almost two years. All that said, anything can happen in 2013 wrt the fiscal cliff. Personally I wish the USA would make the grand leap - badly needed for its economic (and political) healing. The USA is actually in a Structural Depression so the apparent dismal economy is all smoke and mirrors anyway - propped up by five massive trillion dollar deficits.

     

    TRI chart: http://bit.ly/pfbeJm
    23 Nov 2012, 02:48 PM Reply Like
  • New Low Observer
    , contributor
    Comments (2123) | Send Message
     
    Author’s reply » Greetings Freddy,

     

    Thank you for continuing to follow our attempts at economic forecasting. Unto itself, Dow Theory is suppose to include all economic data. However, the fallback position is that the theory is not infallible. So we'll have to see how this ultimately plays out. Overall, we're in agreement that things aren't so great.

     

    I guess it is a matter of timing, in general. Your models seem to be well in advance of the general recognition of the fact. The appealing aspect of Dow Theory, is that I don't have to be flawless in analysis (I'm just not that smart).

     

    Best regards.
    24 Nov 2012, 01:14 AM Reply Like
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