The Dow Report: The Dow Theory Non-Confirmation

By Tim W Wood CPA, February 27, 2004

We looked at this a couple of week ago. I just wanted to take a brief look at it again today and point out that this situation has not corrected itself. You can see on the chart below that the Transports continue to hold above their 50% level as defined by George Schaefer's 50% principle. According to the 50% principle, this does have bullish implications for the Transports. This level is marked by the red horizontal line. The negative side of this coin is that the Transports violated their previous secondary reaction low, which occurred on November 21, 2003 at 2,837.42 on a closing basis. This level is marked by the blue horizontal line. It is the violation of this level that indicates the trend for the Transports is now down. So, the story remains the same, in that, unless we can see the Transports move above the January high at 3,080.32 on a closing basis, the non-confirmation is still at play.

A Look at Other Non-Confirmers

Let's now take a look at the Philadelphia Semiconductor Index known as the SOX. This index is presented in the lower chart below. The upper chart below is the Industrials. Notice that this index bottomed ahead of the Industrials back in early 2003. The SOX found its bottom in February while the Industrials and the S&P 500 found their bottoms in March. In this case, the SOX set up a positive divergence with the DJIA and thereby served as a leading indicator. This was true with the NASDAQ as well. Now we are seeing just the opposite. The SOX topped out with a high close on January 12, 2004 at 560.65, while the Industrials moved higher into February 11, 2004 with a closing high of 10,737.70. So, the SOX is now setting up a negative non-confirmation with the Industrials. The non-confirmation of the SOX just serves to confirm the other non-confirmations seen by the NASDAQ, the Transports and even other indexes.

Below I have also included a special report by Tony Cherniawski. Tony is a Chartered Financial Consultant and President of The Practical Investor in Lansing Michigan. My reason for including someone else's material in this issue of The Dow Report is because I want you to see that there are indeed other market professionals that truly understand the current financial times. I want you to see that it’s not just Tim Wood, Jim Puplava and a few others, that we all know, who have been accused of just being perma bears. No, folks there are others who understand and see this market for what it is as well as what likely lies ahead. You will see as you read Tony's report that he too likens the recent advance to that seen between November 1929 and April 1930. I sincerely hope that you will listen to these warnings.

Have a great weekend,

Tim W. Wood

Position Report
February 2004

New Times Call for New Thinking

Buy-and-hold, indexing and passive asset allocation strategies have been staples of investment plans during the 80's and 90's. The bull market was kind to investors and the brief (cyclical) bear market experiences were overcome by patiently waiting them out. This led to several erroneous assumptions; namely, that (1) the market would always make investors "whole." And (2) an investor could improve his returns by "buying the dips." It was taken for granted that the trend of the market was always "up, up and away!"

Despite the protestations of Wall Street, the trend in the market has changed dramatically, leaving those with the view of a "kinder and gentler" market with heavy losses. Wall Street was generally convinced that the initial bear market declines were only brief pullbacks leading up to the next big advance in the market. The reaction to the preliminary declines in the bear market set the tone for what was to follow.

What followed in 2003 will likely be recorded in future history books as a bull trap, a sucker's rally and a speculator's paradise. Investors focused on a narrow list of stocks that were nearly bankrupt (Internet and telephone stocks) or financial stocks, which benefited from the low interest rate environment; oblivious to the idea the interest rates were at a 45-year low and bound to rise. This rally was not technically strong, and was potentially doomed to a complete retracement.

Optimism and Speculation

The evidence of intense optimism and speculation in the market is apparent in the following observations:

The volume on the OTC bulletin board (penny stocks and those companies which were de-listed from the exchanges) grew to exceed total volume traded in the NYSE for the first time ever in January 2004.
The "flight towards junk" was readily apparent in the volume of newly issued "high yield bond" initial public offerings, which were all oversubscribed in the last 6 months of 2003.
The Chicago Board of Options Exchange reported that in January 2004 they recorded the lowest ten-day ratio of puts to calls ever on January 20, 2004.
In January, the American Association of Individual Investors poll showed the bullish percentage exceeding 50% over the percentage of bears for a record shattering 25 consecutive weeks.
The Yale School of Management's confidence poll shows that 95% of individuals and 91.74% of institutions believe that the market will rise over the next year.
"All the indicators everyone has relied on for years are ineffective," said one prominent chartist that is often quoted on CNBC. "This rally has another couple of years left," quoted another analyst.

One of the key lessons being repeated from the early bear market in 2000 was that the indicators didn't fail. By flashing longer and more persistently than before, they simply broadcast the size of the reversal to follow. Fundamentally, the markets are even more overbought, overloved and overpriced than they were in 2000. All but a few bears had given up their outlook.

As simple as A - B - C

A view from the top of the market in 1999 left us breathless and confident of our success. The markets seemed to go up forever. There were only two brief "scares" in the market, the first in 1987, which culminated in a 20.46% loss in a single day in the S&P 500 index and the second in 1998 where the market plunged by more than 20% in a period of six weeks. Since the most commonly accepted definition of a bear market is a market plunge of 20% or more, the nineteen-year period from 1981 to 1999 was barely eventful. A whole generation of baby boomers became accustomed to prosperity seemingly guaranteed forever and a market that always went up.

Page 80, Elliott Wave Principle by Robert Prechter Jr. and A. J. Frost

Used with permission from Elliott Wave International.

Then came the technical breakdown of the markets starting in 2000. After the initial shock and surprise were overcome, the reaction of Wall Street was that this was a colossal buying opportunity. The investor public was urged to buy even as each downturn became more and more damaging. This initial decline, which lasted form January (or March) 2000 to October 2002 shall be known as wave A. Its duration was 31 months long.

Wave B, which lasted from October 2002 to the present, was focused on the beaten-up telephone, technology, and Internet stocks. These three sectors average gains for this period were104.5%, 141% and 189.5%. The Philadelphia Bank index and the Dow Jones Industrials, by comparison, gained 65.7% and 47.4% respectively during the same interval. Most investors shunned blue chip stocks as they raced to make up their losses from wave A in the dicier secondary issues.

A well-known Dow theorist, Robert Rhea described the Primary Bear Markets as having three phases. Rhea stated, "A Primary bear market is the long downward movement interrupted by important rallies. It is caused by various economic ills and does not terminate until stock prices have thoroughly discounted the worst that is apt to occur. There are three principal phases of a bear market: The first phase represents the abandonment of all the hopes upon which stocks were purchased at inflated prices; the second reflects selling due to decreased business and earnings, and the third is caused by distressed selling of sound securities, regardless of their value, by those who must find a cash market for at least a portion of their assets. Each of these phases seems to be divided by a secondary reaction, which is often erroneously assumed to be the beginning of a bull market. Such secondary movements seldom prove perplexing to those who understand Dow theory."

Robert Prechter and A. J. Frost described a particularly familiar B wave in their book, Elliott Wave Principle. Page 80 carries this description, "The rise from 1966 to 1968 was a wave B in a corrective pattern of Cycle degree. Emotionalism had gripped the public and "cheapies" were skyrocketing in speculative fever, unlike the orderly and usually fundamentally justifiable participation of the secondaries "The Dow Industrials struggled unconvincingly upward throughout the advance and finally refused to confirm the phenomenal new highs in the secondary indexes." This very description may be used for the advance of the equities markets since October 2002.

Here comes the BIG ONE.

Observe the chart of the 1929 to 1932 bear market: Note that wave A occurred between September and November 1929. Wave B lasted from December 1929 to April 1930. Wave C extended from May 1930 to July 1932.

As the B wave ends, we must prepare for wave C. Prechter's and Frost's book, Elliott Wave Principle describes wave C as follows, "Declining C waves are usually devastating in their destruction. It is during these declines that there is virtually no place to hide except cash. The illusions held during waves A and B tend to evaporate and fear takes over. C waves are persistent and broad. 1930-32 was a C wave. 1962 was a C wave. 1969-70 and 1973-74 can be classified as C waves. Advancing C waves within upward corrections are just as dynamic and can be mistaken for the start of a new upswing, especially since they unfold in 5 waves."

A common relationship in the wave pattern is that C waves are at least as large as A waves and are often more powerful. The A wave lasted 31 months. Therefore, it follows that the C wave should last at least 31 months. In the A wave, the Standard & Poors 500 index lost approximately 50% of its value. In the upcoming C wave, the S&P 500 is likely to lose more than 50% of its value. There is a chance that the next wave will be a 3^rd wave, instead of a C wave. If it is, the markets will decline with tremendous volume and large price movements. It will likely extend far beyond our expectations for a C wave.

Doomsday or Opportunity?

Please re-read the bold print two paragraphs above. Wave C may be large and powerful, but it will not go straight down. This will provide the investor that has the proper tools to position himself the ability to profit many times over in a declining bear market. The Practical Investor has developed a tool called the Monthly Trading Cycle Indicator (MTCI). The On-Target Trading System using MTCI is available via subscription by e-mail for do-it-yourself investors. The Practical Investor also provides the NDX Trader, SPX Trader and Fidelity Trader managed accounts as well as fully managed accounts through the Bull/Bear Strategies and the Prudent Bull Strategies (no inverse funds) for managed portfolios. For more information contact The Practical Investor by e-mail or visit our website at www.thepracticalinvestor.com.

*Disclaimer: All recommendations made and/or investment transactions undertaken by The Practical Investor, LLC involve risk of loss. Investors should ascertain their personal risk tolerance level before making any investment decisions. The Practical Investor, LLC will not be held responsible for any losses that might occur from the information acted upon that is provided in its newsletter, or buys or sells made for its managed portfolio clients.

Tim W. Wood

Contact Information

Tim W. Wood CPA
Cycles Man
1545 Gulf Shores Pkwy, PMB #251
Gulf Shores, Alabama 36542
(504) 208-9781 Tel
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