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Thursday, October 25, 2012

Dow Theory

There are plenty of articles on the internet about Dow Theory if you are not familiar with it.  Basically, the idea is the Dow transports should be confirming new highs and lows with the Dow industrials.  Some people claim it has no value and others believe in it very seriously.  There are not very many stock market theories more then 100 years old that anybody talks about.  If the theory had absolutely no value, nobody would be talking about it today.  I think there is significant value to the theory, but it is not a great market timing tool in the short term.  I prefer to compare the indexes on monthly charts just to see what is happening with them.

Lets start with a big historical picture. Here are two very long term charts of the two indexes.


I have put some lines on the charts to mark significant price areas of interest.  After WW2, both indexes eclipsed their late 30s peaks signalling the worst of the great depression was probably over.  Both indexes consolidated in the late 40s before turning up in earnest in the early 50s.  In the late 50s, the industrials made a new high not confirmed by the transports.  Nothing too bad happened to either index, but they traded sideways until after the Cuban missile crisis of 1962.  That run up lasted until 1966.  We can see some slop and chop in the late 60s with neither index clearly breaking out to new highs.  In 1973, the industrials made a slight new all time high while the transports were still significantly below their prior peak.  The worst bear market for the industrials in the 1966-82 secular bear market happened after that clear non confirmation by the transports.  The rally that started in 1982 clearly pushed both indexes to new highs and the grandest secular bull market in history was born.

My historical data starts in 1978 for the transports.  Lets zoom in and look a little closer at the two indexes.

Before the crash of 87, that we just passed the 25th anniversary of, both indexes were at all time highs together.  I have studied the market for that time period and I have to say that is a top that really had little or no warning such a big move down was coming.  I think there are two reasons for it.  One was simply the huge move up over the previous 5 years without any serious sell offs.  This left a lot of people sitting on big profits.  When the market started to correct for real, there were plenty of people that wanted to lock in profits.  The real driver of the crash itself appears to be the idea of portfolio insurance.  Some guy came up with the idea that you could sell S&P 500 futures to hedge your portfolio.  The idea in and of itself was not all that bad.  The problem is that when you have a large group of money managers selling futures to hedge their portfolios it sent the market spiraling down.  That in turn caused the managers to sell even more futures which caused more downside which caused the managers to ...  Both indexes were at new highs together before the crash, and the economy did not go into recession after the crash.

Moving forward in time, we can see the transports took out their 1987 high well in advance of the industrials.
Before the 1990 recession and sell off, the transports and industrials had diverged for many months.  There was a warning there.  The market was in a secular bull stage so the sell off was not all that big.  Both indexes consolidated in 1991.  In late 1991, both indexes broke out to new highs for the year.  Notice the industrials were at new all time highs, but the transports were not.  They were at new yearly highs though, just not all time highs.  In 1992, there was a market pullback and the sell off in the transports was bigger then the industrials which had made a new all time high.  Looking at these indexes over a bigger multi-year time frame there was a divergence, but in the shorter yearly time frame there wasn't.  No recession happened.  By 1993 the transports had made a new all time high and cleared up the multi-year divergence.  The market made a big huge run the rest of the 90s as the next big bubble was forming.

Lets fast forward the chart some.

In 1998, both indexes were at new all time highs in close proximity in time.  There was a big sell off in late 1998, but no recession and the market quickly recovered.  Things changed in 1999.  The transports topped in 1999, eight months ahead of the industrials.  The market had a prolonged bear market that included a recession.  The action in the indexes in 2002 and 2003 is pretty interesting.  The industrials made new lows below the 2001 lows, while the transports did not.  That was a non confirmation, however the next bull market did not get going yet.  I believe this was likely because of the Iraq war.  Without that war, I think the 2002 low would have been the last low.  In 2003, the transports made a new low, while the industrials did not.  This non confirmation as the main Iraq war was ending did launch a new bull market.  Lets fast forward a little more.

In 2005, the transports made a new all time high not matched by the industrials for more then a year.  The industrials did make a multi-year high though.  The market kept on plugging away.  In Oct. of 2007, the industrials made a slight new all time high not matched by the transports which had topped four months earlier.  A recession started in Dec. of 2007.  As a result of the raging emerging market economies the transports made a slight new all time high in 2008 that was not confirmed by the industrials.  This is similar to the action between the indexes in 2002 and 2003 in reverse.  The worst sell off since the great depression followed those two non confirmations. 

Looking at these historical charts it is clear that divergences between the indexes often precede major turning points.  Divergences can exist over long periods of time.  There were clear divergences between the two before every recession since 1990.  That would seem to validate that the theory still works, even if some would try to make an argument against that.  The biggest problem is actually applying it because of the time span between divergences.  This gets very complicated when there are multi-year type divergences.  For instance the industrials broke their 2003 low in the last bear market while the transports did not.  That non confirmation was probably a clue that the world was not ending yet.  The result was another huge rally.  Lets look at where we are now.

There are a bunch of things going on here.  In 2011, the transports made a new all time high not confirmed by the industrials more then a year later.  This year the industrials eclipsed their 2011 high in the spring and this fall they got above that high.  The transports did not get above last years high in the spring.  They also have not gotten above their spring high to this point.  What does all this mean?  I think this qualifies as one of those complicated situations.

Lets look at the shorter term divergence first.  The last two bear markets and recessions had initial index divergences of eight and four months.  We currently have a divergence lasting more then a year.  Is that forecasting a recession again?  There is quite a bit of economic data that is signaling that could be the case.  The cause of this divergence is the global economic slowdown.  It is inhibiting the transports at the same time sending money to the U.S. for a safe haven.  Some of that money is ending up in the industrials.  I think the next few months will clear this up significantly.  If this is signaling troubles for the stock market, we should be headed down for real very shortly if not already started.  If the transports make a new high for the year then the odds of trouble would go down tremendously.  That seems pretty unlikely to me since it has not happened so far with unlimited QE and all.

What about that multi-year divergence between the two indexes.  We have had similar divergences in the past.  Some have had significant meaning, some not so much.  Is this a serious divergence or one that will clear up in time?  This is one problem with Dow theory.  In 1973, a similar multi-year divergence happened before the worst bear market of that secular bear market period.  We also had multi-year divergences in the late 50s and early 90s where nothing bad happened.  Those occurred during a secular bull markets though.  There was a multi-year divergence in 2005 and 2006 as well where nothing bad happened.  That was during a secular bear market.  That was mitigated by the industrials making new bull market highs, just not new all time highs.

Lets put the demographic chart up again and think about it in terms of this long divergence.


We have a multi-year divergence during a big down swing in the demographic chart.  I think it is certainly possible another big crash is coming.  It might even be bigger in down side or last longer then the last two bear markets.  In the worst case scenario, it could last long and be bigger on the downside.   The non confirmation in 1973 that preceded the nasty bear market of 73-74 had a low monthly ADX value very similar to what we have today. 

Maybe all this is a bunch of hog wash and there is no predictive value to Dow Theory.  But, what if there still is?  I believe there is ample evidence in these charts the theory is valid, just difficult to apply.  I also believe the theory may be indicating another very bad crash is about to begin.  For those that have not planned what they might need to do in that event, there is still time.  I highly recommend it, just in case.


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The information in this blog is provided for educational purposes only and is not to be construed as investment advice.