It's as Basic as 1-2-3

A Tangible Perspective

By James J Puplava CFP, October 22, 2002

One of the basic tenets of technical analysis is that the markets at any one time swing in trends. There are three basic trends. There is the longer-term trend known as the primary trend, which can last for more than a year and in fact may run beyond several years. The next trend is called a secondary trend, which is an important reaction to the primary trend. The secondary trend runs contrary to the basic or primary trend. In a bull market, a secondary trend would be a corrective move in the markets and in a bear market it would be a temporary rally. These trends can last from as little as three weeks to three months. The final trend is called a minor trend. Minor trends may last from a week to as long as several weeks. Primary and secondary trends can’t be manipulated. Only minor trends can be altered from their path to a desired outcome, but only for a short period of time.

The primary trend is equivalent to the tides. Bull markets are comparable to incoming tides. Bear markets are similar to a receding or ebbing tide, a tide that is going out. During these tidal flows there are waves and ripples that occur within the incoming or outgoing tide. These waves are intermediate trends, which can be primary or intermediate depending on their movement against or with the direction of the tide. The smaller movements within the waves are analogous to the markets' Minor trends.

The DOW Theory is the grandfather of all technical analysis studies. It was formulated and articulated more than a century ago by Charles Dow, the founder of the Dow-Jones Financial News Services. Dow was the originator of the Dow theory that bears his name. His successor, William P. Hamilton, organized and formulated the theory during a period of 27 years as editor of the Wall Street Journal in his daily writing. The Dow Theory is still widely followed today with Richard Russell its foremost proponent.

The theory is useful for distinguishing long-term trends in the market. The theory isn't infallible. It has been found to be more useful in its discernment of long-term trends. The theory is less useful in warning of changes in secondary trends. This does not preclude it from being helpful to investors, though. Speculators or short-term traders would find little use for the theory other than knowing the primary trend of the markets. However, for investors the theory is helpful in its ability to identify long-term trends in the market. In this sense, once a primary trend is identified the investor could go long this trend and ride it until that trend is discredited. For example, if the primary trend in stocks is a bull market trend the investor could go long the markets. In the same way if the primary trend of the markets is down, the investor could either stay out of the markets in cash or go short the markets. The primary objective of the long-term investor is to catch these primary waves or trends within markets and ride them until the trend changes.

The most important question that should be asked by investors today is what is the primary trend of the markets. As shown in these graphs of the Dow, the S&P 500, and the NASDAQ, the primary trend is down. This means we are still in a bear market.

As these graphs show, their rallies occur along the long-term trend lines that run contrary to the primary trends. These moves or bounces can either be secondary or minor, depending upon their length in time. However, the one distinguishing feature of these graphs is that they give a clear picture of the primary trend. We are still in a bear market no matter what kind of spin comes out of Wall Street. The current rally is nothing more than a minor reversal trend in a primary bear market.

The chart of the S&P 500 shows a large topping formation known as a head and shoulder formation which is a major reversal pattern as shown in the decline in the S&P 500.

The S&P 500 is down 22.5% this year. The S&P 500 has lost 42% from its peak back in March of 2000. The other major averages have also lost ground. The Dow has lost 28% from its peak in January of 2000 while the NASDAQ has lost over 74%. The Dow and the S&P 500 have lost less ground because of the movement by investors, primarily institutions, to the larger and perceived less risky stocks of the Dow and the S&P.

Bear markets can retrace much of the gains of the previous bull market. In the case of this bear market, it is viewed as the biggest and longest lasting bear market since the Crash of 1929 and the Great Depression. It is shaping up to be the granddaddy of all bear markets that is still in its infancy. There is nothing fundamentally that would change that view. It doesn't matter whether it is earnings, economic measures, such as industrial production, unemployment, orders for durable goods, factory utilization or more recently retail sales, the fundamentals look bad on both the economy and earnings. That is why stocks are down. If investors look closely at the trend in earnings and the statements coming from companies, they all hold one common theme. Earnings are down and companies don't see much improvement in the year ahead. It doesn't matter if it is IBM, GE or TI; it is clear things are trending down, or at best remain uncertain. Beating analysts' estimates in this environment is meaningless and a fool's game if followed or believed by investors.

There is another trend that is emerging which is reflected in the price of gold and precious metals shares and the rise in the CRB.

There is a movement out of paper and into things and it is becoming universal.

Chart formations on gold and precious metals stocks show that a new primary trend is emerging in "things," which is irrefutable as shown in these charts above.

As the table below illustrates, the returns in precious metals shares and in the CRB dwarf the losses in stocks this year.

Year-to-Returns By Market

Dow Jones Industrials	-15.68%
Dow Transports	-12.41%
Dow Utilities	-38.13%
S&P 500	-22.47%
Nasdaq Composite	-33.72%
NYSE Composite	-19.24%
Value Line Arithmetic	-23.43%
Wilshire 5000	-21.88%
Amex Gold Index	71.69%
Phil. Gold & Silver Index	16.41%
CRB Index	13.16%

There is a clear gulf between the performance last year and this year between precious metals and hard assets. You hear very little about this on Wall Street or the financial media other than an occasional acknowledgement or otherwise some sort of disparaging comments. Markets move in cycles. Nothing is ever permanent; bull markets change into bear markets and bear markets turn into bull markets. It has been this way for well over a century. It is a history lesson that has been forgotten by most investors and analysts on Wall Street.

It is a lesson that has to be relearned by every generation and unfortunately, it is a painful lesson. The soundest investment advice that can be given to an investor is to determine the primary trend, get on board once it begins, and ride it until it clearly ends. The primary trend in paper is a bear market, and in "things" a new bull market is just beginning.

US stocks fell for the first time in nearly a week as fresh new evidence of a declining earnings trend came from Texas Instruments, Kimberly-Clark, UPS, Wyeth and Pharmacia. A major adjustment still needs to be made to fourth quarter earnings estimates, which remain too high. Analysts are forecasting pro forma Q4 profits of 17.1%. This estimate has come down from 22.9% in September. It looks like Q4 pro forma earnings will come in at 6.5% versus the original estimates of 30% in January, and 17% in July.

Volume came in at 1.51 billion shares on the NYSE and 1.72 billion on the Nasdaq. Market breadth was negative by 22 to 10 on the big board and by 19 to 13 on the Nasdaq. Underneath the surface of this rally is a real weakening taking place in momentum. Volume is weak, market breadth is declining, and there is a series of lower highs, which don't bode well for the market. I believe this to be lack of investor participation. Most investors are using market rallies as exit points as money continues to flow out of stock funds. This will eventually put more pressure on funds to sell stocks. Despite today's downtrend in stocks, bond prices still fell after a feeble attempt to rally.

On the dockets next week are the Fed's beige book report on economic conditions and the elections in Brazil. The Fed's next meeting will be on November 6^th, after the elections. The markets are forecasting a 40% chance of a quarter-point reduction in interest rates. That percentage has declined from earlier estimates.

Overseas Markets

European stocks fell as investors speculated that lower oil prices will reduce earnings at energy companies such as BP Plc and Shell Transport & Trading Co. ABB Ltd. slumped after abandoning its 2002 profit forecast. The Dow Jones Stoxx 50 Index shed 1.1% to 2573.91. The Dow Jones Stoxx 600 Index fell 0.9% to 213.36, with oil shares accounting for most of the decline. Seven of the eight major European markets were down during today's trading.

Japanese stocks fell, with the key benchmarks completing their biggest two-day drops in seven weeks. Computer-related shares such as NEC Corp. slumped after Texas Instruments Inc. said fourth-quarter profit will miss analyst forecasts as orders decline. The Nikkei 225 Stock Average fell 3.2% to 8689.39.

James Puplava

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James J. Puplava CFP
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