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What is the Dow Theory Saying?

(February 27, 2005)

Dear Subscribers and Readers,

Last week, I described my beliefs that we were in “no man’s land” and that the best strategy was to adopt a wait-and-see approach in terms of initiating new long positions in the stock market. I still stand by this strategy. I think Monday’s decline in the major indices is ominous, despite the fact that the market managed to recover nicely by the end of the week. Again, please keep in mind that what I am discussing here is only the broad market, and that if readers can find individual bargains (which is still relatively difficult to come by nowadays) in the stock market, then readers should go ahead and buy them. I will continue to articulate in the following commentary on why I believe we are in “no man’s land” – along with a refresher on the Dow Theory and what the Dow Theory is trying to communicate to us at this time.

Before we go on, let’s review the latest action by looking at the familiar daily chart of the Dow Industrials vs. the Dow Transports:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (January 1, 2003 to February 25, 2005) - 1) The Dow Industrials is now only 13 points away from surpassing a new recovery high! 2) The Dow Transports is finally cooperating with the Dow Industrials on the upside, as the former rose 2.63% in the latest week while the latter rose 0.52%.  The DJIA is now only 13 points from posting a new recovery high, while the DJTA is still 96 points (2.5%) away.  The million-dollar question is: Can the DJTA surpass its all-time closing high again in the coming weeks?

Readers should note that the Dow Industrials is now only 13 points away from a new recovery high – a high that was made two months ago on December 28th. Despite the Dow Transports rising over 2.6% in the latest week, it is still the lagging index, and is an index that we should keep an eye on going forward. The key question is: Can the Dow Transports surpass its all-time closing again in the coming weeks (it has been nearly two months since it made an all-time high on December 28th)? If not, then the relative underperformance of the Dow Industrials since over the last 12 months could prove ominous going forward. Wait Henry, what are we saying here and why the bearishness?

Okay, let us step back and think about this for a second in Dow Theory terms. We know that the Dow Transports made an all-time high of 3,811.62 on December 28th. Meanwhile, the Dow Industrials made a new 52-week high on the same day, but it failed to make an all-time closing high (in fact, it was about 850 points away from making an all-time high). This is a PRIMARY NON-CONFIRMATION. I have emphasized this before but let me do so again. A primary non-confirmation occurred prior to both the severe 1969 to May 1970 and 1973 to 1974 cyclical bear markets (all within the 1966 to 1974 secular bear market). The first primary non-confirmation occurred when the Dow Industrials failed to confirm the Dow Transports in making an all-time high in December 1968, while the second occurred when the Dow Transports failed to confirm the Dow Industrials in making an all-time high in January 1973. The following two charts track the action of the Dow Industrials vs. the Dow Transports during the period immediately prior to those fateful periods. The first chart shows the daily closes of the DJIA vs. the DJTA from January 1, 1968 to December 31, 1969:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (January 1, 1968 to December 31, 1969) - 1) A PRIMARY Dow Theory non confirmation occured in December 1968 when the Dow Transports made an all-time high while the Dow Industrials failed to concurrently make an all-time high (the Dow Industrials was ten points away from surpassing its all-time high of 995.20 made in February, 1966).  The subsequent underperformance of the Dow Industrials over the next two months proved very ominous, indeed. 2) Double top and lower high in the Dow Transports and a huge underperformance in the Dow Industrials!

As noted on the chart, a primary Dow Theory non-confirmation occurred in early December 1968 when the Dow Industrials failed to confirm the Dow Transports when it failed to make an all-time high. The Dow Transports did make an all-time high, but after a decline in December and January (during a span of two months which is very close to the time period between now and the high that we saw back on December 28th), it retested its all-time high but failed to surpass it. At the same time, the performance of the Dow Industrials severely lagged – setting up one of the greatest cyclical bear markets in U.S. stock market history.

The second chart shows the daily closes of the DJIA vs. the DJTA from January 1, 1972 to December 31, 1973:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (January 1, 1972 to December 31, 1973) - A PRIMARY Dow Theory non confirmation occured in January 1973 when the Dow Industrials made an all-time high while the Dow Transports failed to concurrently make an all-time high (the Dow Transports was 3.8 points away from surpassing its all-time high of 279.5 made in December 1968 nine months earlier).  The fact that the Dow Transports severely lagged the Dow Industrials over the last nine months proved very ominous - a precursor to the 1973 to 1974 bear market.

The action prior to the 1973 to 1974 bear market was very different to the action leading up to the 1969 to May 1970 bear market, but it also involved a primary non-confirmation when the Dow Transports failed to confirm the Dow Industrials when the latter made an all-time high while the former fell short . There were many more warning signs prior to the 1973 to 1974 bear market, as evident by the severe underperformance of the Dow Transports during the nine months leading up to the all-time high in the Dow Industrials (most probably as a result of the threat of the Oil Embargo).

So what now? Right now, we have a PRIMARY non-confirmation unless the Dow Jones Industrials also make an all-time high in the next six to nine months. I believe this is a big hurdle – a big hurdle that will be difficult to overcome given the bearish indicators (declining liquidity, continuing tightening by the Fed, a continuing rise in energy prices, and a possible overheating in the Chinese economy) that I have been discussing during the last few weeks. I do not believe that the current market has priced in all these bearish factors. In fact, if we follow the 1968 scenario, then the decline in the major indices may be about to begin. However, it should be noted here that both the Dow Industrials and the Dow Transports are still technically healthy – but any relative underperformance in any of the two Dow Indices from now on should bear watching going forward (in fact, I am already worried since the performance of the NASDAQ Composite has been lagging quite a bit during the last couple of months).

Now, let’s focus on the non-technical aspects of Dow Theory but which is probably more important – as the concept of valuation of stock prices actually form the basis of the Dow Theory. Despite the fact that earnings has been rising rapidly since late 2002, the valuation of stock prices and specifically, the S&P 500 is still very high on a historical basis (as measured by P/E and Price-to-Dividends ratio). Following is a couple of fundamental charts courtesy of Decisionpoint.com which illustrates this fact perfectly. The first chart shows the S&P 500 vs. what it would be on a historical basis if it was trading at a P/E of 10 (undervalued), 15 (fair valued), and 20 (overvalued):

S&P 500 Index Relative to Normal P/E Range 1925 to 2005 - Please keep in mind that the S&P 500 has historically swung to both undervalued and overvalued levels and back again.  The current P/E of the S&P 500 is still over 20, suggesting that equity prices in general are still too high for comfort.

For investors who believe that we are in the midst of a secular bear market not unsimilar to the 1966 to 1974 bear market (as I believe), it may be a good idea to ask how the S&P 500 performed during that fateful time vs. its P/E levels. The following chart illustrates this action perfectly by showing the above chart but compressed into the 1950 to 1980 period:

S&P 500 Index Relative to Normal P/E Range 1950 to 1980 - In the first bear leg of the 1966 to 1974 secular bear market, the S&P 500 declined marginally below the level it would have been if it was trading at a P/E of 15 (as represented by peak earnings, i.e. the highest earnings level up until that time).  In the second bear leg (which is where we should be now), the S&P 500 declined 20% below the level it would have been if it was trading at a P/E of 15 (again, as represented by peak earnings).  A similar bear leg today would ultimately (assuming 10% earnings growth this year) give us a bottom of approximately 700 in the S&P 500.

As I stated in the above note – if the cyclical bear market is to reassert again in the next six to nine months and if we are to follow the 1969 to May 1970 scenario, then the upcoming bear would ultimately have us trading at a P/E level of approximately 12 (based on peak earnings). While this would not represent a huge undervaluation of the S&P 500, it would at least give us a slightly undervalued stock market – something which we have not seen since late 1990. This would represent a huge buying opportunity.

Obviously, no one can predict how the stock market will perform over any period of time, but the Dow Theory is definitely telling us to be cautious here. Anyone who is buying growth stocks or stocks/ETFs in emerging markets here should take heed.

Outside of the Dow Theory, I am still advocating cautiousness based on what I said last week – with an emphasis on the continuing ominous action in the Bank Index. The relative strength of the Bank Index is again lower (but only marginally, however) in the latest week, as shown in the following updated chart from last week:

Relative Strength (Weekly Chart) of the Bank Index vs. the S&P 500 (February 1993 to Present) - 1) The last time the relative strength of the Bank Index broke down in a significant way was during the July 1998 period - and we all know what happened afterwards. 2) The decline in relative strength of the Bank Index after the LTCM and Russia crisis and during 1999 suggested tougher times ahead for the U.S. stock market -- and in retrospect, it was cold-bloodedly right. 3) Relative strength of the Bank Index finally broke through support convincingly a week ago and is again lower in the latest week - suggesting that the cyclical bull market is now in danger.  Again, in the more intermediate term, this most probably suggests a developing liquidity crunch (perhaps in a marginal country like China or in a marginal industry like the mortgage financing companies) sooner rather than later.

Again, the relative strength of the Bank Index vs. the S&P 500 has now convincingly broken below its support line dating back to May 2003 and has now spent nearly two weeks convincingly below support. Unless the Federal Reserve start cutting the Fed Funds rate next month (the next FOMC meeting is March 22nd) – which is HIGHLY UNLIKELY, then it is very difficult to see how the relative strength of the Bank Index can bounce back above support. Please also keep in mind that the fact the Bank Index has breached support from such a high level definitely makes this latest breakdown more authoritative.

Another relative strength chart that we have shown previously and which we think is also very important is the relative strength of the RTH (the Retail HOLDRS) vs. the S&P 500. Following is the most up-to-date weekly chart of the relative strength of the RTH from May 2001 to the present:

Relative Strength (Weekly Chart) of the Retail HOLDRs vs. the S&P 500 (May 2001 to Present) - 1) Relative Strength of the RTH bottomed and reversed in January 2003 - providing clues a major market rally was under way. 2) Relative Strength of the RTH topped and reversed a few months before the broad market topped. 3) Over the last couple of weeks, the relative strength of the RTH vs. the S&P 500 has been steadily weakening - suggesting that the RTH has not been keeping pace with the broad market (for example, WMT is now very close to its 52-week low).  Since the relative strength of the RTH has historically been a leading indicator, the oulook for the market is now bearish.

As I have said many times before, the relative strength of the RTH vs. the S&P 500 has been a very reliable leading indicator of the stock market in the past – i.e. retailers tend to lose strength ahead of most issues in the stock market. The latest downtick in relative strength of the RTH makes the latest reading the lowest reading since early August and most probably signals a further weakening in the stock market up ahead.

Another relative strength that is of interest (and which I have not posted in awhile) is the relative strength chart of the Oil Index (the XOI) vs. the S&P 500. Following is the weekly chart of the relative strength of the XOI vs. the S&P 500 from August 1983 to the present:

Relative Strength (Weekly Chart) of the Oil Index vs. the S&P 500 (August 1983 to Present) - Relative strength in the American Exchange Oil Index vs. the S&P 500 has continued to hold above its resistance level (which dates back to late 1991) - suggesting that the era of low oil prices is official over and that even higher oil prices may actually be ahead!

Since the last time I spoke about the Oil Index and its relative strength vs. the S&P 500, it has convincingly stayed above its support line and has even made further gains. Relative strength of the XOI vs. the S&P 500 is now at a high not seen since January 1991! Now, before I go on any further, please take a look at the following chart (updated last Friday) courtesy of the Bank Credit Analyst:

U.S.:WTI Crude Oil Price and Crude Oil Bullish Sentiment

The jist of the BCA’s message is this: Despite high oil prices during the last year, the demand for oil still has not been curtailed. In fact, the demand for oil (even in China) is as high as ever and any potential decline here is nowhere in sight. Moreover, despite the relatively high oil prices, sentiment (courtesy of Marketvane.net) in oil prices still has not risen to any extreme bullishness yet to call for a decline. From a contrarian point of view and from looking at the continuing increase in relative strength in the XOI vs. the S&P 500, there is a chance we may see an oil price close to $60 a barrel in the coming weeks. The era of low energy prices is also most likely over. If that is the case, then I don’t believe equity prices in general (except for the energy sector, of course) will perform well over the coming weeks.

Anyway, there are already too many charts here so I am not going to post the charts of the popular sentiment indicators this week but I will devote a paragraph to them. As I mentioned in our Thursday morning’s commentary last week, the latest Investors Intelligence Bulls-Bears% Differential declined slightly from 35.4% to 32.7% in the latest week. The Bulls-Bears% Differential in the AAII survey, meanwhile, declined from 6% to 0% in the latest week, suggesting an oversold market based purely on this indicator. At the same time, the Market Vane’s Bullish Consensus declined from 67% to 63%.

Readers should make up their own mind about the readings of the popular sentiment indicators because I am not that clear on them right now and I certainly would not buy anything based on the oversold readings that we are getting purely from the AAII survey. There is still no confirmation from the Investors Intelligence Survey and we still have not seen a sub 60% reading in the Market Vane’s Bullish Consensus since late August of last year (again, my ideal reading for a bottom in the stock market is still the 50% level). Moreover, given the bearish implications that I am getting from the Bank Index, the RTH, and the XOI, it is still probably best to wait it out on the sidelines here before buying. Readers please stay tuned.

Signing off,

Henry K. To, CFA

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