The Dow Report: Dangerous Times

By Tim W Wood CPA, September 10, 2004

The danger of the current market environment continues to mount. The talking heads and politicians on TV continue to tell us how great the economy is. I can’tdeny the fact that the market has indeed been rather resilient. It is this resilience that I believe makes the current environment so dangerous. To the casual observer it may appear that the bearish case is no longer valid because we have held up so well. Yet, the bullish case is iffy simply because of the fact that the market topped some six months ago and has since just chopped back and forth. This has served to confuse and frustrate both the bulls and the bears. This has also served to keep both the bulls and the bears hopeful. My technical work leads me to believe that this market is just as dangerous and maybe even more so than it was in 2000.

Let's look at a few facts to try and help us sort out the details. First of all, hardly anyone is afraid of this market. Everyone knows that it can’tgo down. This is clearly shown by the VIX. The VIX measures market expectations of near term volatility as conveyed by stock index option prices. The VIX is a "fear gauge" and is now at levels not seen since early 1996. There is simply no fear.

My friends, Peter Eliades and Robert McHugh, both use a ratio between the S&P 500 and the VIX. Below I have included a chart of the S&P 500 with this ratio at the top. On September 3, 2004 this ratio closed just over 80. On September 9, 2004 this ratio closed at 79.83. You can see that since the February top any push above 80 has occurred within days of the cycle top. The 2000 high for this indicator came on August 28^th at 83, only 4 days before the short term cycle top which preceded a 450 point drop in the S&P 500 and a 2,300 point drop by the DJIA. Yes, complacency is dangerously high.

The most interesting aspect of this extreme complacency or lack of fear is that it is occurring in conjunction with some very bearish underlying technical conditions. One such condition is the Dow theory sell signal, which occurred way back in September 1999. I have referred to this Dow theory sell signal as the "master sell" signal because of the fact that it occurred in the third phase of the late great bull market. We still remain under this "master sell" signal today. Since this "master sell" signal we had a major Dow theory non-confirmation which occurred at the 2000 top.

Also, since this "master sell" signal and Dow theory non-confirmation we have seen the development of secondary Dow theory sell signals and non-confirmations. We still currently remain under the March 2004 Dow theory secondary sell signal. Since this signal we have also seen a series of Dow theory non-confirmations. We had a down side non-confirmation at the May 2003 low. Then, at the June high, we saw a Dow theory upside non-confirmation and in August we had another Dow theory down side non-confirmation. These non-confirmations can be seen on the chart below.

Robert Rhea warned numerous times in his writings that when the averages disagree, they are shouting, "be careful." Many may be thinking that these Dow theory non-confirmations and sell signals just aren't working anymore. This too is dangerous thinking. The Dow theory has been around and proven itself for well over 100 years and I have little doubt that it will again prove correct. The problem is that people grow impatient. The market action of the 1990's has trained the public to believe in the buy and hold strategy and that the market always goes up. It is this conditioning and lack of market knowledge that creates this impatient and complacent behavior. It is this impatient and complacent behavior that is reflected in the VIX. This impatient and complacent behavior is what is going to allow the bear to totally devastate those who were trained like Pavlov's dog in the 1990's.

If you will notice in the chart above it was some 18 months from the September 1999 "master sell" signal before the market made a real decisive break in 2001. This decisive break did not come until a year after the bear market "master sell" signal was confirmed. So, just because the market hasn't fallen apart in the wake of these more recent Dow theory warning does not invalidate the theory or the warning. Only price action can invalidate these warnings and to date this has not occurred.

Robert Rhea also wrote that the markets required "infinite patience." I totally agree and I'll add that it also requires infinite discipline. I understand the frustration that this market has been dealing us. This is the bear's job. After all, Dow theory suggests that we are in a monster bear market and it does make sense for the bear to deal us hand after hand of monster frustration. But, it is my belief that as long as these Dow theory warnings remain in effect we have to take heed of the warnings. Failure to do so will likely prove disastrous.

Things are always the most bullish at the top and all of the political leaders will tell you so. They will continue to tell you so all the way down to the bottom as well. The Dow theory does tell the truth if we will listen. Just prior to William Peter Hamilton's confirmed Dow theory sell signal Roger W. Babson tried to warn the public of the dangers. On September 5, 1929 Roger W. Babson wrote, "Sooner or later a crash is coming which will take in the leading stocks and cause a decline of from 60 to 80 points in the Dow-Jones barometer." The following good news was spread in the face of a confirmed Dow theory sell signal which Dow theorist William Peter Hamilton warned of and confirmed in October 1929. Few listened to these guys because it simply wasn't what they wanted to here. No, the public wanted to here that everything was going to be OK, that this time was different and that the Dow theory was bunk.

September 1929
"There is no cause to worry. The high tide of prosperity will continue." - Andrew W. Mellon, Secretary of the Treasury.

October 14, 1929
"Secretary Lamont and officials of the Commerce Department today denied rumors that a severe depression in business and industrial activity was impending, which had been based on a mistaken interpretation of a review of industrial and credit conditions issued earlier in the day by the Federal Reserve Board." - New York Times

December 5, 1929
"The Government's business is in sound condition." - Andrew W. Mellon, Secretary of the Treasury

December 28, 1929
"Maintenance of a general high level of business in the United States during December was reviewed today by Robert P. Lamont, Secretary of Commerce, as an indication that American industry had reached a point where a break in New York stock prices does not necessarily mean a national depression." - Associated Press dispatch.

January 13, 1930
"Reports to the Department of Commerce indicate that business is in a satisfactory condition, Secretary Lamont said today." - News item.

January 21, 1930
"Definite signs that business and industry have turned the corner from the temporary period of emergency that followed deflation of the speculative market were seen today by President Hoover. The President said the reports to the Cabinet showed the tide of employment had changed in the right direction." - News dispatch from Washington.

January 24, 1930
"Trade recovery now complete President told. Business survey conference reports industry has progressed by own power. No Stimulants Needed! Progress in all lines by the early spring forecast." - New York Herald Tribune.

March 8, 1930
"President Hoover predicted today that the worst effect of the crash upon unemployment will have been passed during the next sixty days." - Washington Dispatch.

May 1, 1930
"While the crash only took place six months ago, I am convinced we have now passed the worst and with continued unity of effort we shall rapidly recover. There is one certainty of the future of a people of the resources, intelligence and character of the people of the United States - that is, prosperity." - President Hoover

June 29, 1930
"The worst is over without a doubt." - James J. Davis, Secretary of Labor.

August 29, 1930
"American labor may now look to the future with confidence." - James J. Davis, Secretary of Labor.

September 12, 1930
"We have hit bottom and are on the upswing." - James J. Davis, Secretary of Labor.

October 16, 1930
"Looking to the future I see in the further acceleration of science continuous jobs for our workers. Science will cure unemployment." - Charles M. Schwab.

October 20, 1930
"President Hoover today designated Robert W. Lamont, Secretary of Commerce, as chairman of the President's special committee on unemployment." - Washington dispatch.

October 21, 1930
"President Hoover has summoned Colonel Arthur Woods to help place 2,500,000 persons back to work this winter." - Washington Dispatch

November 1930
"I see no reason why 1931 should not be an extremely good year." - Alfred P. Sloan, Jr., General Motors Co.

January 20, 1931
"The country is not in good condition." - Calvin Coolidge.

June 9, 1931
"The depression has ended." - Dr. Julius Klein, Assistant Secretary of Commerce.

August 12, 1931
"Henry Ford has shut down his Detroit automobile factories almost completely. At least 75,000 men have been thrown out of work." - The Nation.

July 21, 1932
"I believe July 8, 1932 was the end of the great bear market." - Dow Theorist, Robert Rhea.

Below is a chart of this period. The Dow theory served William Peter Hamilton well at the top as he was proven right in spite of what the talking heads and political leaders were spouting. At the bottom Robert Rhea was also served well by understanding and using the Dow theory to identify the bottom of that great bear market. In the current case the Dow theory has spoken and I will place my trust with the Dow theory over anything any political leader or any TV wise guy has to say about the current market conditions. You have been warned again!

There are ways to make money in this very difficult environment. To do so requires an understanding of the technical picture, enormous patience and discipline. If you're looking for a source that will teach, help you to understand and learn more about the current technical picture then you should visit www.cyclesman.com and consider Cycles News & Views.

Tim W. Wood

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Tim W. Wood CPA
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