DOW Theory Confirmation?
by Mark Phillips
mphillips@optioninvestor.com
Created and refined by its inventor, Charles Dow, DOW Theory
attempts to divine the future of the broad market by focusing on
Value. Price action is important, as are other indications such
as moving averages, volume, confirmations and divergences. Much
talk emerged during the great boom of the late 1990s that perhaps
DOW Theory was a form of market analysis that had outlived its
usefulness. Perhaps, perhaps not. I remember a lot of
discussion from the same timeframe that Warren Buffet had become
irrelevant as well, due to his abject refusal to invest in
anything he didn't understand - namely technology. Well, the
past 2 1/2 years have proved once again that the Oracle of Omaha
knows what he's doing, as he continues his decades-long pursuit
of compelling values.
I'll be the first to tell you that I am a novice when it comes
to understanding the nuances of DOW Theory, but there are some
important tenets of the theory that I have learned and feel are
quite important to determining where we are and where we might
be heading.
First though, let's cover just a bit of history. Charles Dow
began publishing a little paper called the Wall Street Journal
back in 1889. Perhaps you've heard of it? GRIN From 1899-1902,
Mr. Dow wrote a series of articles for the WSJ, which later
were published in a book entitled "The ABC of Stock
Speculation". Since then, the great "DOW Theorists" like
William P. Hamilton, Robert Rhea and George Schaefer have
provided their own interpretations and enhancements to the DOW
Theory. But when it is all said and done, it comes down to
values.
One quote from Mr. Schaefer that I particularly like is, "It is
always safer to assume that values determine prices in the long
run. Values have nothing to do with current fluctuations. A
worthless stock can go up 5 points just as easily as the best,
but as a result of continuous fluctuations, the good stock will
gradually work up to its investment value." Or put more simply,
in the long run, value is paramount. It sure seems like that is
an accurate portrayal of what has come to pass in the stock
market in the past couple years.
From what I have been able to learn over the past couple years,
each of the great DOW Theorists have added their own flavor and
interpretations to this method of market analysis, but the basic
tenets that Charles Dow put forward a century ago are still at
the core of DOW Theory. To my knowledge, Richard Russell is
the current reigning authority on DOW Theory and he publishes a
daily newsletter where he talks about the daily market action and
how it relates to DOW Theory. For those that are interested in
learning more than I could ever pass on to you, Mr. Russell has
written a number of interesting articles on his site,
dowtheoryletters.com.
Recall that DOW Theory is based on Value. On that measure alone,
we would be hard pressed to say that we are anywhere near a major
bear market bottom. The S&P Composite is currently selling at
just over 33 times earnings, with a dividend yield of a paltry
1.79%. At bear market bottoms, PE ratios should be close to half
their current reading, while dividend yields should be at least
triple their current level. That sort of metric only adds
credence to the idea that this is just another bear market rally.
I recall reading an article by Mr. Russell back in late 1999,
where he called a beginning to the bear market that we've clearly
been in since the end of the first quarter of 2000. He was
talking about the issue of confirmation, where (I believe) the
NYSE Composite failed to set a new high, while the DOW went on
to new highs. This was an important divergence in DOW Theory.
With the DOW, NASDAQ and S&Ps still screaming to new all-time
highs, not a lot of attention was paid to his statement that we
were now in a bear market. Just another old-school fuddy-duddy.
Well, maybe not! Since that point in time there have been
numerous confirmations and non-confirmations, between the Dow
Industrials, Dow Transports and Dow Utilities. DOW Theory says
that for confirmation of a bull (or bear market) a new high (or
low) in one of these indices must be confirmed by a corresponding
high (or low) in the other indices. A failure to achieve that
confirmation is regarded as a divergence.
Most recently, I've been watching the action between the Dow
Industrials (INDU) and Dow Transports (TRAN). Back on October
9th, the INDU dropped to a fresh bear market low of 7286 (close),
which was accompanied by the TRAN setting a fresh bear market
low of 2013. Even better, the Dow Utilities (DJU) also fell to
a fresh bear market low of 167. That's a solid double
confirmation. So why did the markets then do an about face and
post an impressive rally over the past 2 weeks? Here's a
clue -- it's a bear market rally.
Something we have to keep in mind is that DOW Theory is NOT a
trading tool. It is an analysis method that helps us to determine
the long-term nature of the market. DOW Theory is currently
telling us that the long-term trend for the market is down, as it
is currently in the clutches of a mighty and angry bear. But that
doesn't mean he can't take occasional breaks to digest what he's
just eaten.
In fact, I've noticed that major confirmations between the TRAN,
INDU and DJU frequently lead to important reversals in the broad
market. In other words, the confirmation often becomes a
powerful contrarian indicator over the near-term. Does that mean
DOW Theory is useless? Not by a long shot! But I think that
most of the time, when that major confirmation presents itself,
most (if not all) of the move in that direction has already
happened, at least for that leg of the cycle. That was certainly
the case in September of 2001.
The panic following the terrorist incidents pushed both the INDU
and the TRAN to new lows. That confirmation was good for a
solid 6-month rally in both indices, with the INDU gaining more
than 30% and the TRAN advancing by nearly 50%. But what has
happened since then? Earlier this month, both indices fell to
new bear market lows, on the same day. Is it a coincidence that
the Dow Industrials are up more than 1300 points since the
intraday low below 7200 on October 10th? I don't think so.
Using the rally off last year's September lows as a guide, I
would say that the rally we are currently experiencing likely
has a fair amount of room to run. And that dovetails nicely with
other more familiar indicators such as the PnF Bullish Percent
readings and the oscillators on weekly charts of the major
indices.
I believe the important information currently being conveyed by
DOW Theory is that we are still deep in a powerful bear market.
This rally will run its course just like every other one for the
past 2 1/2 years and then we will be faced with another vicious
decline. Trade this rally for all it's worth, but don't fall
for the illusion that this is the end of the bear. And I think
that is the important utility of DOW Theory. It helps us to
retain perspective on the longer-term direction of the market
while doing what we do best - trading the shorter-term trend as
long as it lasts.
I hope that helps!
Mark |
