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Manuel Blay
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Investor and Trader As investor I'm deeply influenced by Dow Theory. I focus on the primary trend (1-2 years). My trading is short-term based (avg trade duration 4-5 days).
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Dow Theory Investment
  • Dow Theory Update For May 12: Stocks Make Confirmed Higher Highs  0 comments
    May 12, 2014 5:35 PM | about stocks: SPY, DIA, IYT, GLD, SLV, GDX

    Richard Russell on valuations

    I have written in the past that I am very skeptical as to the yardsticks used in order to determine values. Among many reasons, I believe that using a fixed figure like PER>20 "expensive" is self-defeating as the total capital stock of the economy changes and the underlying rate of discount changes too. This is why "value" measures of the cheapness or dearness of the stock market have failed miserably since the last 20 years.

    I feel that any value measure should be "relative" to recent readings, thus reflecting the contemporary situation of our economy (and the capital stock, which indirectly has some bearing on the rate of discount). It makes no sense comparing PER readings of the roaring twenties with PERs of the twenty-first century. Any value measure should be relative to the more or less recent past.

    Hence, I like and I find elegant the way Richard Russell, of the "Dow Theory Letters" has found to conclude that stocks are expensive now:

    "Current P/E divided by the average P/E of the preceding decade. We are now 53.3% above the average P/E of the preceding decade. There have been only three times when valuations calculated by this method were higher -- the late 1920s, the late 1950s and 2007 just before the bull market ended. Judging from current valuations, we are either near the beginning of a bear market -- or facing a decade of sub-par performance from stocks."

    Russell's measure makes sense, since we are just comparing our current PER with the average PER of the preceding decade. This makes more sense. The economy may change in ten years, but, nonetheless, it will be more similar to the PER readings found 100 years ago. Thus, in a very buoyant economy a PER of 20 might not be "expensive" if the average of the last 10 years has been 19.

    Accordingly, I feel that Russell's measure might be right, and I feel that stocks are priced for perfection.

    So, what should we do as investors?

    1) We should bear in mind that value considerations are important when investing along the secular trend (which may last more than 10 years). However, those concerned with the primary trend (which lasts significantly less, let's say between 1-2 years), should not be put off by the dearness and cheapness of the stock market.

    2) I am not a fool, and I know that after five years of advancing prices, the market is more susceptible to a secular bear market. Furthermore, and I agree with Russell, we are not seeing a "bargain" market. However, I also know that nobody knows when this primary bull market will end. And I also do know that the classical (and even better, Schannep's) Dow Theory will signal soon enough (let's say ca. 10% below the market top) when it's time to run for the exits.

    3) Accordingly, even though I like to know where I stand, as far as valuations are concerned, I know that I will not act on this information.

    4) However, if I were a secular investor, I would definitely run for the exits, as my investment decisions would be based on values and not on technically-based "timing".

    5) Please bear in mind that market pundits have been complaining that the market has been expensive for a long time now. However, the market impervious to such warnings continued to make higher highs, and those value-based investors were left on the sidelines (Richard Russell, included). While certainly this bull market run will eventually run out of gas, we don't know when will it happen. Personally, I prefer the following technically based wager: I have open ended profits (as nobody knows whether the markets will still advance +10, +20 or even +40%) against a likely loss of -10%, should the markets start to fall in earnest right now (-10% is the most likely loss from the top as per past primary bear market signals).

    Let's turn on to the markets.

    US Stocks

    The SPY and Industrials closed up. All three indeces exceeded the last recorded closing highs, which is bullish.

    The primary trend remains bullish, as explained here, and more in-depth here.

    The primary trend was reconfirmed as bullish on October 17th, 2013, and November 13th, 2013 and March 7th, 2014, for the reasons given here, here and here.

    So the current primary bull market signal has survived three secondary reactions.

    The secondary trend is bullish too, as explained here and here.

    Gold and Silver

    SLV, and GLD closed up. For the reasons I explained here, and more recently here the primary trend remains bearish.

    For the primary trend to turn bullish, SLV and GLD should jointly break above the secondary (bullish) reaction highs. As a reminder, the secondary reaction closing highs were made on August 27th, 2013. From such highs the market declined without jointly violating the June 27th, 2013 primary bear market lows.

    Here I analyzed the primary bear market signal given on December 20, 2012. The primary trend was reconfirmed bearish, as explained here. The secondary trend is bullish (secondary reaction against the primary bearish trend), as explained here.

    On a statistical basis the primary bear market for GLD and SLV is getting old. More than one year since the bear market signal was flashed has elapsed. However, I am extremely skeptical as to the predictive power of statistics. I prefer price action to guide me, and the Dow Theory tells me that the primary trend remains bearish until reversed.

    Furthermore, the June 27, 2013 lows remain untouched. The longer this situation lasts, the higher the odds that something might be changing. But I wait for the verdict of price action.

    As to the gold and silver miners ETFs, SIL, and GDX closed up.

    I profusely explained that SIL and GDX set up for a primary bull market signal. You can find all the relevant information from a Dow Theory standpoint here.

    Please mind that a setup is not the real thing. So the primary trend has not turned bullish yet (or maybe "never").

    The secondary trend is bullish, as explained here. In spite of short term bullish accomplishments, SIL and GDX are not in a primary bull market.

    The primary trend for SIL and GDX remains, nonetheless, bearish, as was profusely explained here and here.

    The secondary trend is bullish, as explained here. In spite of short term bullish accomplishments, SIL and GDX are not in a primary bull market.

    The primary trend for SIL and GDX remains, nonetheless, bearish, as was profusely explained here and here.

    Sincerely,

    The Dow Theorist

    Themes: Dow Theory Stocks: SPY, DIA, IYT, GLD, SLV, GDX
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