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The Dow Theory as Interpreted by Richard Russell

(June 22, 2002)

Friends of mine know that I am a genuine "fan" and student of the Dow Theory.  I have read past writings by Charles H. Dow, William P. Hamilton and Robert Rhea, and I believe today's premier interpreter of the Dow Theory is Richard Russell (see article below).

I believe the primary consideration for the Dow Theory is VALUES. Following the bullish primary trend is all about buying stocks at a great value at the beginning of the bull market (that will be 1982) and holding on until the end of the bull market (early 2000).  Everything else is secondary.

According to Richard Russell, the greatest bull market in history ended in September 1999 (he called it back then - not now).  He also states that we are nowhere near the end of the current bear market (which I would independently agree with even before reading his commentaries).  When this bear market ends, common stocks would be trading at "great values."

So how does one define "great values?"  S&P 500 P/E ratio 10?  8?  6? Dividend yields of 5%?  7%?  Dow Jones Industrials at 1,500 or 3,000? Dow-to-gold ratio at 1?  FYI, based on the 1930's and the 1970's bear markets, this current bear market will probably end when we reach some of the above levels.  Right now, the S&P 500 P/E ratio is at 40, dividend yields are less than 1.5%, and the DJIA's latest close is 9,253.79.  We are nowhere near close.

The above are mere yardsticks, of course.  If the stock market has taught me anything, it is that there is never a price that is too low or too high.  For all I know, the Dow, at its low, could decline another 90% from here. Who would've thought five year ago that the market cap of Yahoo would've been twice the market cap of GM at the height of the bull market?  Or Enron declaring bankruptcy?  Or how about imagining the Nasdaq losing 70% of its value in 18 months while you were counting your winners back in the spring of 2000?  I remember being called a lunatic back then when I was telling people that the 18-year bull market ended on April 4, 2000 - the day the Nasdaq had an intraday crash of 15% or 575 points.  When it comes to the stock market, nothing is impossible.  The arrogant, ignorant, stubborn, and stupid gets killed, and unfortunately when it comes to the stock market. probably over 80% of the population has all four traits.

Rather, all the phases of the bear market are identified not by rates of decline nor by P/E ratios, but by a condition in investors' psychology. The three phases of a bear market are: Denial, Hope, and Capitulation. Judging by what I have been seeing, we are currently still in the second phase.  The bear market will only end after the Capitulation phase.  This is the phase when every segment of the population decides to give up and sell - whether it's a Dow 30 stock, a Nasdaq 100 stock, a pharmaceutical or consumer durable stock (so-called defensive stocks), a financial stock, or even the latest stars such as security stocks, or REITs such as NFI and AXM.  The third phase is the scariest phase.  It is a phase when anything that can go wrong will go wrong.  Not unsimilar to the late 1990's but in reverse. These are just some guesses but I believe gold will soar over the 1980 high of $850, the real estate bubble will (finally) pop, unemployment will be near or over 10%, and the DJIA will crash below 5,000.  One thing is guaranteed, though: this bear market will be more devasting than any of us has or will be able to fathom.

For people who have been out of the market, though, this should be welcomed.  During the third phase, pessimism will be rampant.  People who have been proclaiming Nasdaq 6,000 back in 2000 will be proclaiming the death of the stock market.  Again, don't listen to them.  This third phase represents the cleansing out of the last stubborn "investors" (I call them gamblers), and after these people have sold out, a secular bull market will begin again (this has to happen, by definition).  Values will be rampant and I will guarantee you would be taking an early and comfortable retirement (for those of us who are currently aged 30 or below anyway... hmmm...) if you do manage to get in at that time (just make sure you don't buy any of the crap called Cisco, Oracle, Intel, etc.).

Or let's put it this way: Former boss of mine told me over lunch a few months ago that some people were asking him when was the right time to get into stocks again.  He related this question to me.  I don't think I ever answered that question.  Ironically, the best time to buy stocks would be when those same people who asked you that question are not asking that question any longer.  In other words, when no one is buying stocks, that would be perfect opportunity to buy them.  The difficult part would be knowing which stocks to buy (index funds are always safe but I would not buy stocks such as Microsoft, Intel, Cisco, Oracle or Yahoo ever again - the leaders in the former bull market will not be the leaders in the new bull market).

Following is an article on the Dow Theory:

Dow Theorists battle it out

NEW YORK (CBS.MW) -- Call it the battle of the Dow Theorists.

Of the three market timers monitored by the Hulbert Financial Digest who employ the venerable Dow Theory, two are bullish and one is bearish. And even the two bullish theorists disagree on what would trigger a sell signal.

The reason that such disagreements can exist among timers attempting to follow the same timing system: William Peter Hamilton, the original author of the Dow Theory, never codified it into a series of unambiguous rules. He instead introduced it in dribs and drabs in editorials for the Wall Street Journal in the first three decades of the last century.

To be sure, the general outlines of the Dow Theory are clear enough: A bull market is confirmed when the Dow Jones Industrials Average and the Dow Jones Transports Average jointly reach significant new highs, while a bear market is signaled when both averages reach significant new lows.

Market turning points occur when the two averages trend in opposite directions--"non confirmations" in Dow Theory parlance.

Dow Theory Forecasts' Richard Moroney turned bullish on the Dow Theory in mid-March. That was 1100 points ago, and Moroney recently has engaged in some serious soul searching about what the Dow Theory is saying today. According to Moroney, the bull market definitely needs to prove itself here with the DJI and DJT surpassing their March highs of 10,635.25 and 3,049.96, respectively. Conversely, a close below their September lows (8,235.81 and 2,033.86) would be a clear sell signal.

The other current bull among the Dow Theorists is Jack Schannep of The Dow, though he turned bullish last fall and therefore he is not in the red to the extent Moroney is. According to Schannep's reading, the Dow Theory will remain on a buy signal so long as the DJT fails to join the DJI in closing below their May lows. This means that the level to watch is a DJT close below 2,643.10.

This trigger point almost was violated last Friday, June 14, when the DJT closed at 2,673. The market has a bit more breathing room today, with the DJT closing at 2,733.68.

The current bearish interpreter of the Dow Theory is Richard Russell of Dow Theory Letters, who argues that the Dow Theory turned bearish in 1999. Russell insists that, when introducing the Dow Theory, Hamilton always focused on more than just the Dow Averages, and always interpreted movements in the Averages in the context of overall stock market valuations. Given today's sky-high valuations, therefore, Russell is unlikely to turn aggressively bullish even if both Dow averages were to make new all-time highs.

Why even bother with the Dow Theory if there can be such serious disagreements? Because there really is something to the theory. Three finance professors, two at Yale and one at NYU, have recently used artificial intelligence software--specifically, a neural network--to take all of Hamilton's original WSJ editorials and define the precise patterns that Hamilton said presage rallies and declines. They then used this neural net to time the market from 1930 until today. The system worked -- beating buying and holding by an extraordinary annualized 4.4 percentage points from 1930-1997.

Unfortunately, the professors have not applied their neural network to today's market. With two of these three Dow Theorists currently bullish, one is tempted to give the nod to the bullish interpretation. There's just one problem with doing that: Russell has the best record of the three. In fact, Russell has the best market-timing record over the last two decades of any monitored by the Hulbert Financial Digest.

Henry To

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