The Primary Trend is Down!
By James J Puplava CFP, August 2, 2002
Majoring in Dow Basics
Charles Dow, in his editorial commentary at the turn of the century, formulated what would later become The Dow Theory. Although his theories would be put together later and amplified by others, the central tenets of his theory have become one of the basic tools for analyzing markets. Dow believed the markets have three movements that are all going on at the same time. They are known as the major, secondary, and minor movements in the markets.
The first movement is the minor movement reflecting what is going on day to day. This is followed by a secondary trend, or short-term swings that can last from two weeks to six weeks or more. The major trend is the primary movement in the market, which lasts long-term and can encompass time periods covering four years or more.
In addition to these three movements, Dow formulated trend confirmation indicators such as higher tops and bottoms to confirm a bull market, and lower tops and bottoms to confirm a bear market, to which he added the confirmation of the Industrial and Rail Averages. If a Bull Market was in place, a rise in the Rails (now the Transportation Index) would rise along with the Industrials. If a Bear Market was the primary trend, a fall of the Rails with the Industrials would confirm the Bear Market trend. The idea behind the confirmation of the Industrials and the Rails is that things being made and sold would have to be shipped. If sales fell, manufacturing would contract and there would be a decline in transportation of goods.
Others would come along after Dow, putting his theories together and refining them such as S.A. Nelson, William P. Hamilton, who became editor of the Wall Street Journal after Dow's death, and Robert Rhea, who became the Dow's historian and record keeper to Richard Russell, today's leading Dow theorist. Even though Dow's theories were formulated over a century ago, they are still relevant and followed to this day. Many of his theorems have been refined to form the central tenets of technical analysis. Technical analysis has been refined and improved over the last century and has advanced significantly with the aid of computers and the Internet. Even though these theories were formulated over a century ago, they have just as much meaning today as they did more than a century ago, especially Dow's theories of primary trends.
Distracted From Today's Primary Trend
This is the subject that occupies this week's closing Market Wrap-Up. In viewing this week's market action, it appears the markets have gone back to their primary trend, which is a downward movement in a continuing bear market. What is important for investors to understand is the primary trend. The primary trend is one of a bear market. There is so much background noise every day in the media that obscures this fact. There are a plethora of opinions voiced each day that are nothing more than useless drivel. Various reasons as to why an investor should be buying a stock are as numerous and as large as the losses that have occurred in this bear market which began over two years ago. Such tripe as "The markets rallied over investors" optimism over the rescue of trapped miners over the weekend," or "Executives hauled off to jail," are ludicrous and insulting to one's intelligence. I call them distractions because they keep investors from focusing on what is important and what is obvious. We have a repertoire of standard clich's for keeping investors in this market and keeping them confused. They all have a familiar ring such as "the second half recovery," "we're close to a bottom," and my favorite, "stocks are cheap."
In the words of Charles H. Dow, "The best profits in the stock market are made by people who get long or short at extremes and stay for months or years before they take their profit." Dow went on to say, "The best way of reading the market is to read from the standpoint of values" In reading the market, therefore, the main point is to discover what a stock can be expected to be worth three months hence" It is often possible to read movements in the market very clearly in this way. To know values is to comprehend the meaning of movements in the market." One of Dow's contemporaries, Samuel A. Nelson, confirmed this by saying, "Value has little to do with temporary fluctuations in stock prices, but is the determining factor in the long run."
What we can learn from studying Dow and many of his followers is that the primary trend in this market is down. We are in a bear market whose primary trend is down. It is that simple. You can forget all of the background noise. It's just clutter designed to keep you distracted and confused. Forget that stocks are cheap (with the one exception being natural resource). Moreover, at today's high prices, even after the declines of the last 28 months, stocks are hardly bargains. The S&P 500 is selling at 31 times trailing earnings with a dividend yield of less than 1.8%. The Dow is trading at 23 times trailing earnings and offers investors a dividend yield of 2.2%. At the bottom of bear markets, P/E multiples get as low as 7 and dividend yields get as high as 6-7%. We are still a long way off from stocks becoming cheap. If you want cheap, look at the energy sector, which is what Warren Buffett is doing.
Despite the carnage of the last few days, the markets actually ended up on the plus side for the week. The S&P 500 rose 1.3% for the week and is down 24.7% for the year. The Dow gained 0.6% with YTD losses of over 17%. The Nasdaq was the exception this week losing 1.1%, bringing its YTD losses to over 36%. The week was up, but the primary trend is still down as evidenced by the YTD numbers.
We may be heading for more problems next week that will take a healthy dose of intervention to avoid. There is now a full-scale banking crisis emerging globally with systemic risks everywhere that could be amplified by the leverage in the financial system from derivatives. With bankruptcies and junk bond defaults at record highs, there are huge counterparty risks that lie waiting to erupt. Someone somewhere is on the wrong side of these trades. The following is a sample of the systemic risks that are starting to emerge. Friday, Societe Generale, France's second largest bank, reported a 41% decline in second-quarter net income as a result of taking a $371 million hit for bad loans. The same day in London, Lloyds TSB said it has become the latest to be hurt by turmoil in the world financial markets. The bank said it was increasing its loan loss reserves by 50% to cover loans it made to Enron, WorldCom, and Argentina. There were rumors also circulating around that one of the nation's largest airlines is close to going under. Business Week intimated that UAL may file for bankruptcy this year. A spokesman for the airline declined to comment on the Business Week story.
Still Watching The Banks
With Brazil now on the ropes, the IMF is considering giving the country more time to repay its $11 billion in loan payments due next year. We now see bankruptcies rising, companies as well as countries defaulting on their debt, credit spreads widening, and one has to wonder, Who is next? There is too much debt and the growth in derivatives has only compounded this situation. Over the last few weeks, worries and concern has started to spread over the nation's top three banks and their exposure to derivatives. The current exposure exceeds J.P. Morgan Chase's net equity. Even as large as Citigroup is, their current exposure could cause severe problems for the banks, especially if systemic risks throughout the world's monetary system start to multiply as we are now starting to see unfold.
In fact, given the extent of their derivative book and considering that they are in all of the wrong places, it is hard not to imagine that one of these three banks are headed for trouble, if not all three. The banks are supposed to have risk control measures in place. Yet with derivative books this large, it doesn't seem possible they can avoid the occurrence of future problems. In the case of JPM, their derivative book of $23.4 trillion and equity base of $40 billion is all that covers $51 billion in potential credit risk, not mentioning the $68.8 billion in derivative risk exposure. These three banks are in all of the wrong places -- corporate loans, loans to emerging markets, and counterparties to a Titanic-size derivative book. Add to this the fact that most of the derivative books of these major banks are of the OTC variety -- which means they are far riskier and less liquid -- it isn't too imaginative to envision more problems occurring. A lot of the derivative business is based on blind faith and assumptions. These are the assumptions that are built into the derivative risk models that provide the theoretical pricing for much of these complex instruments.
"It's So Derivative"
|J. P. MorganChase||$23.4 Trillion||$68.8 Billion|
|Bank of America||$9.8 Trillion||$6.9 Billion|
|Citigroup||$6.6 Trillion||$22.4 Billion|
Source: Office of the Comptroller of the Currency as of March 31, 2002. Table courtesy of Matthew Goldstein, "Bank Derivatives Back on Radar," 8/2/2002
It is the complexity of these instruments and the prevalence of problems in the international system that is now causing central bankers and investors to worry. As I said above, someone somewhere is going to come up on the wrong side of these trades. At this time we don't know who. We just have clues.
Looking Like A Double-Dip Recession
The economic numbers this week are showing the economy is starting to slow down again and that the recession was much deeper than originally thought. On Friday the government reported the economy created fewer jobs than expected and that the unemployment rate remains stubbornly high. Factory orders fell 2.4% in June and many more companies are reporting a slowdown in sales and profits. The economic numbers this week have already caused one major Wall Street firm to predict the threat of recession will cause the Fed to lower interest rates again. Goldman Sachs, which predicted a rate hike because of a strong economy only five weeks ago, is now calling for the Fed to lower interest rates again in order to thwart another recession. Some question this move given the large contingent of foreign ownership in our financial markets. Lower interest rates would now be considered an act of desperation that could cause foreign investors to panic and exit our markets. Currently, interest rates are more attractive overseas, especially in Europe.
This week Trim Tabs reported that money flowed into equity funds in a delayed reaction to a jump in stock prices. Last week $20.5 billion flew out of stock funds. For the month of July nearly $48 billion flowed out of stock equity funds. This follows outflows last month that were close to a record $48 billion.
What we have seen this week and this quarter is a number of clues on the economy and on earnings that call into question a second half recovery. The economy was much weaker than originally thought and shows signs of new weakness. Corporations continue to report weak sales and profits and there are new signs of retrenchment in spending on the consumer front. It is hard to make a case at this point for a second half recovery. In fact, it is much easier to predict the economy will lapse back into a recession instead of a strong recovery. In summary, the primary trend is for the bear market to continue and for the economy to head back into recession. In addition, there is even a greater risk that the Perfect Financial Storm is coming closer to fruition as barometric gauges in the financial system have taken a sudden drop.
The Dow Jones Stoxx 600 Index of European shares headed for its first weekly gain in four weeks as drugmakers including GlaxoSmithKline and tobacco companies such as Gallaher Group rose. Zurich Financial Services slid as Merrill Lynch & Co. cut its profit forecast for the insurer. The Stoxx 600 erased a gain of as much as 0.6% and closed 0.2% lower at 217.82. It has climbed 1.3% since last Friday. The narrower Stoxx 50 Index added 0.1% to 2605.55. Three of the eight major European markets were up during today's trading.
Asian stocks fell, led by exporters Sony Corp. and Samsung Electronics Co., after U.S. manufacturing and job reports indicated economic growth in the region's biggest overseas market is faltering. Japan's Nikkei 225 stock average dropped 0.9% to 9709.66, as of the 3:01 p.m. close in Tokyo.
Treasury prices gained considerable yardage as the week's economic stats provided fodder to those expecting more rate cuts from the Fed. The December fed funds futures contract is currently factoring in a 1.50 percent overnight rate, signaling that the Fed will lop off 25 basis points from short rates by year-end.
The 10-year Treasury note rallied 27/32 to yield 4.285% while the 30-year government bond soared 1 1/8 to yield 5.215%.
© 2002 James Puplava