The Dow Report: A Lesson in Dow Theory
By Tim W Wood CPA, June 11, 2004
On March 10, 2004 a Dow theory sell signal was triggered. I began receiving e-mails at that time from people asking about my interpretation of the signal. For this week's wrap-up I want to share with you a piece from my April newsletter in which I explained this sell signal in detail. Here it is.
A Lesson in Dow Theory
In this issue I want to address some of the confusion that I have seen surrounding Dow's theory. I recently received e-mails asking about my interpretation of Dow theory and if a Dow theory sell signal has been given as a result of the recent market action. I have been asked, "How can one theory be interpreted so differently in that some 'Dow theorists' are bullish while others are bearish?" I will attempt to answer this question in the commentary portion of this issue.
In order to do this topic justice, I feel that we must begin with the 1999-2000 bull market top. I have talked many times in the past about the fact that bull and bear markets unfold in three phases according to Dow theory. The great Dow theorist, E. George Schaefer, defines the Bull market phases as follows, "All Primary Bull Markets consist of three phases-which are separated by more or less severe secondary reactions. The First Phase represents reviving confidence in the future of business; it begins during a period when business is in the doldrums of a depression or recession and in an atmosphere almost totally devoid of optimism or hope. The Second Phase represents a response of stock prices to actual improvements in earnings statements and statistical business indicators, as they occur. The Third Phase represents a surrender of the public to fears of inflation and the lure of speculative profits. Stocks, during this period, are bid to higher and higher levels on little other than hopes and expectations." It should be relatively clear that the last great bull market, which according to Dow theory, actually began in 1974 and ended in 1999, possessed all three of these phases.
The great Dow theorist William Peter Hamilton wrote, "The previous lows or highs made by both averages may best be taken as representing the turn of the market." In looking back and applying this concept we find that the last joint high by the Transports and the Industrials occurred on May 12, 1999. See the daily chart below:
From that point forward the new highs which were seen by the Industrials were unconfirmed. Given that this happened in the Third Phase of the Primary Bull Market, the warnings were evident to those who truly understood the Dow theory. From this May high the markets declined into a minor low in late May. From this low the Industrials advanced again into July. Following this advance another minor low was made in early August. The fact that the early August low occurred at a level above the May low kept the price structure in the Industrials remaining positive. Then from this early August low the Industrials again moved into another new high. This time the decline that followed carried the Industrials below the early August low as they then declined some 1,300 points over the next 7 weeks. This decline was very important as it qualified in both time and price as a secondary reaction, which corrected the advance out of the late 1998 lows. So, we had a non-confirmation between the averages, which occurred in the Third Phase of a Bull Market and then price broke down. On September 23, 1999 the May 27, 1999 low was violated. This combination of events set up what the great Dow theorist Robert Rhea would have called a "Sell Spot" and the trigger to "sell" the market came with the break on September 23, 1999. However, from this secondary reaction low, which concluded in October 1999, the Industrials moved into their all time high. The actual price high occurred on January 14, 2000 at 11,723. Again, none of the advances seen after May 12, 1999 were confirmed by the Transports. So, at the January 2000 high, the averages were not "in gear" thus, the non-confirmation remained. The fact that this non-confirmation occurred in the Third Phase of the Bull Market was warning the Dow theorists that this final advance was suspect. Then, from the January 2000 high, the Industrials once again turned down. This time the decline into the March 2000 low violated the previous secondary reaction low, which had previously concluded with the decline into the October 1999 low. On October 15, 1999 the secondary low close was made at 10,019.70. On February 25, 2000 the market closed at 9,862.12. It was on this day with the violation of the October 15, 1999 low that the Primary Trend of the market was confirmed as being Bearish. Some, who do not truly understand Dow theory, mistake this confirmation as being a sell signal when in reality such a break serves to confirm the earlier "Sell Spot." The opposite would of course be true of a �Buy Spot.� Robert Rhea wrote �A widespread opinion prevails among those who have not studied the subject that Dow's theory implies buying or selling after confirmation of primary direction of the market has been registered. If this were true, then there would be little use in our studying the theory." So, there you have it from Robert Rhea himself. Dow theory does not support waiting on Primary Trend confirmation to buy or sell. Those who say so simply do not understand Dow's theory.
Now, that we have established when and how the Dow theory sell signal and Bearish Primary Trend confirmation occurred let's review a few facts about what would be required to correct this condition. First, you must keep in mind that all of the events described above occurred in the Third Phase of a Primary Bull market. As a result, this makes the importance of these events paramount. Everything else is secondary to these events. These events become the corner stone so to speak. Rhea stated, "Dow's theory holds that the primary trend, once established, must always be considered to be in force until some indications in the averages nullify or reverses their earlier implications." In order to correct or nullify the occurrence of the confirmed Primary Bear Trend one of two things would have to occur. One, both averages would have to move above their previous all time high points seen back in 1999 and 2000. Or two, we would have to see the bear market concluded. In order to see the bear market concluded we would have to see all three phases of the bear market unfold and stocks would then be selling at value levels indicative of a bear market.
Well, we haven't and are not likely to see new all time highs in these averages and stocks have not yet sold at the historically low levels seen at Bear Market lows. For example, history shows me that at true Bear Market lows the dividend yield and the price earnings ratios tend to be roughly equal. In 1932 the S&P yield was 10.50 and the P.E. was approximately 10. In 1942 the yield was 8.71 and the P.E. was 7.3. In 1974 the yield was 5.9 and the P.E. was 7.24. At the March 2003 low the P.E. on the S&P was approximately 30 while the yield was at 1.96, hardly levels seen at true bear market lows. So, this has not occurred either.
Now for the three phases of the Bear Market; E. George Schaefer defines the Bear market phases as follows, "The First Phase represents abandonment of exaggerated hopes upon which stock prices were based when they reached their bull market peaks. The Second Phase reflects poor business and earnings reports as they steadily become worse. The Third Phase plunges the market to its final depths as economic deprivation forces many investors to sell against their wishes, regardless of price, in order to raise cash."
The great Dow theorist, Robert Rhea, described the three phases of the bear market in a very similar way. More importantly, Rhea goes on and states, " Each of theses 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 the Dow theory."
So, I hope that you are now beginning to see the Big Picture. The decline into March 2003 was only Phase I of the bear market. As you all should know, I have maintained that the rally, which began in March 2003, was indeed a Bear Market rally and specifically a rally that should prove to separate Phase I from Phase II of this great Bear Market. The information above is only one of my many reasons for this opinion. In an interview with Richard Russell last summer I asked him if he agreed with this opinion. He confirmed my interpretation of the Bear Market phasing and agreed that we have thus far only seen Phase I. He also agreed that the rally out of the March 2003 low was a Bear Market rally that will likely prove to separate Phase I from Phase II just as Mr. Rhea explained above. For those who would like to see more analysis to support this opinion you should read my October 2002 article, which appeared in Technical Analysis of Stocks and Commodities Magazine. If you would like more information on this article please send me an e-mail. Additional evidence to support this opinion comes from my work with cycles and the Lindsay pattern known as "Three Peaks and a Domed House."
The next issue with Dow theory that I want to address comes in the wake of the March 2003 rally. As you can see on the daily chart below, the rally out of the March 2003 low carried the Industrials above their last secondary reaction high point.
This secondary reaction high point occurred on November 27, 2002 at 8,931.68. Some Dow theorists argue that when the rally out of the March 2003 low surpassed this level, the Primary Trend of the market again became Bullish. It is true that this was a bullish development and it obviously was suggestive of higher prices. However, you must remember that the Confirmed Primary Bear Trend that was established on February 25, 2000 takes precedence. These events must all be viewed in the context of the "Big Picture." It is for this reason that I maintained my long-term bearish views during this long and important rally. I have said it before and I'll say it again. The rally out of the March 2003 low went further and lasted longer than expected. However, this did not change the fact that it was a Bear Market rally. Hamilton and Rhea acknowledged that the shorter-term trends can be manipulated. I think that we can likely all agree that the efforts of the FED helped fuel this rally along. However, my study of the averages shows me that in spite of what seems to be a common belief today, the FED cannot manipulate the Primary Trend of the market and it is indeed bearish.
This brings us to the most recent top seen by the averages. The last joint high for this advance was seen by the averages on January 21, 2004. Two days later the Transports began diverging with the Industrials and the current non-confirmation was born. Given that this occurred after a long rally that had not seen a correction of any substance, this set up what Rhea termed a "Sell Spot." Then when the Industrials broke the previous low, which had occurred on January 13, 2004 at 10,427, the "sell signal" was triggered. This violation and sell signal came on March 10, 2004. I used the violation of 10,367 as my trigger point because that was the intra day low and I simply wanted to add that margin into the equation to further qualify the break. Remember what Rhea said, "A widespread opinion prevails among those who have not studied the subject that Dow's theory implies buying or selling after confirmation of primary direction of the market has been registered. If this were true, then there would be little use in our studying the theory." It is because of this misunderstanding that some are suggesting that Dow theory has not recently triggered a qualified "sell signal." Now in order to have an absolute reconfirmation of the Primary Bear Trend, we need to see the rally that follows the current correction fail to exceed the February high. We then need to see the decline that follows that rally move below the low point for the current correction. At that point, we will have confirmed that the Bear market rally has concluded and that the Primary Bear Market is once again in full swing. This again is what some are waiting for before they call a Dow theory sell signal and again this not the case as Robert Rhea offers further evidence that Dow theory does not suggest waiting for a Primary Trend confirmation in order to create a buy or sell signal. Mr. Rhea states, "Many writers on financial subjects, in their ignorance concerning all matters pertaining to Dow's theory, maintain that those who trade according to the teachings of Dow and Hamilton must only buy stocks after the averages have penetrated previous high points. Whenever I read such a pronouncement, or any other such foolishness, I wonder whether the man who wrote it is disseminating as much false information about stocks, economics, or other subjects, as he is about Dow's theory." Rhea also points out that the same logic applies in both Bull and Bear markets. The only difference is that everything is reversed in the Bear Market. There is no doubt in my mind for my study of the Dow theory that a sell signal was justified with the recent violation of 10,427. We are now simply waiting on the confirmation, not the sell signal.
Tim W. Wood
© 2004 Tim Wood