The Dow Theory in a Globalized World
(May 26, 2005)
Dear Subscribers and Readers,
Ever since the widespread adoption of the internet and the World Wide Web in the late 1990s, there has been a huge proliferation of the use of buzz words such as “convergence,” “flattening,” and of course, “globalization.” Given the low cost of starting up a stock market investment newsletter and the sheer potential of an audience nowadays, it is no surprise that we have also seen a huge explosion in the number of stock market advisory websites. And then there are blogs. The last time I saw, estimates are that there are more than 40,000 blogs being created each day. The amount of information now available at your finger tips – even compared to ten years ago, is mind-boggling.
So what is an investor supposed to do in this day and age? How can one continue to make profitable investment decisions without succumbing to the barrage of information available on the internet, cable, satellite TV, and on one's cell phone? How can one rationally make decisions in an increasingly herd-like and emotional investing world, especially in an environment with over 10,000 hedge funds prying their eyes on every potential money-making opportunity? Not long ago, a hedge fund manager lamented to me that domestically, we are increasingly moving towards a world where “alpha” (i.e. excess returns over the market's return) is getting increasingly difficult to find – and that investing other places (such as Asia) may be the way to go. I will get back to investing in overseas markets in a moment, but regular readers of our commentaries should know that we have often discussed the economic/investment consequences of globalization in our commentaries and in our discussion forum. I have also written three long commentaries on China in late January and early February – which you can find in our archives section on MarketThoughts.com. In the spirit of things, we have also set up an entirely new board on our discussion forum entitled: “The Central & Eastern Europe Board” – which is definitely one of the most dynamic regions in the world besides China and India (in fact, with the Euro's appreciate against the dollar in recent years, SE Europe actually had the strongest growth in income in the world since 2000).
In a world where access to any kind of information is near instantaneous, the playing field may be leveled, but the textbook version of weak-form market efficiency may now be more fact than fiction at any point in our lives. That is, ironically, while the internet has empowered the individual in many aspects of one's life, this “empowerment” has also created a world where “values” and “excess returns” may be getting much more difficult to find – at least on a day-to-day basis (this is a very important point which I will elaborate later in this commentary).
Okay, bottom-line Henry, what am I supposed to do?
Well, for one, you can go the route of this hedge fund manager. I have previously emphasized that investing in China may well be the golden opportunity for some of our readers – precisely because timely and accurate information is still very difficult to find when it comes to investing in Chinese companies or securities – even those of ADRs being traded on the NYSE or the NASDAQ. I have also said that to the extent that I can (along with my contacts in both Hong Kong and China), I will help out our readers who are interested in the “China Story” going forward. (For now, my partner and I are still working on this newsletter on a part-time basis – hopefully, we will be able to transition into this in a full-time endeavor once we get the support of our subscribers later this year!)
But then: Professor Jeremy Siegel, in his latest work “The Future for Investors: Why the Tried and the True Triumph Over the Bold and the New” suggests (after tons of historical research) that historically, not only has the latest and most innovative companies have underperformed the “tried and the true” over the long run when it comes to rewarding their investors, but that this concept has also applied to individual countries as well. That is, if one has invested in countries with the best economic growth rates over the long-run, then one's portfolio would have inevitably underperformed – relative to, say, just investing one's money in the major stock market indices of the United States. I believe Professor Siegel's two major reasons are:
- Investors have invariably paid too high a price for growth stocks or for the securities of a country that has been exhibiting higher-than-average growth. He has labeled this the “growth trap.”
- Most upstart and innovative (e.g. “one-product companies” such as Xerox, Digital Equipment, etc.) companies invariably flame out. Investing in the “Asian Tigers” during the early to mid 1990s right before the Asian crisis is a prime country example.
To which my response is: For over a thousand years, China has had the fastest and most innovative economy in the world – which abruptly ended sometime during the reign of the Qian Long Emperor in the 1700s. The Chinese is a very proud people and has historically had a very capitalist economy. With the adoption of Western management ideas and Western laws, China should emerge as one of the most powerful and sustainable economies in the 21st century. Both China and India today is the real thing. Consider these two very telling quotes from Thomas Friedman in his latest work, ‘The World is Flat: A Brief History of the Twenty-First Century”: “Mircosoft has three research centers in the world: in Cambridge, England; in Redmond, Washington, its headquarters; and in Beijing. Bill Gates told me that within just a couple of years of its opening in 1998, Microsoft Research Asia, as the center in Beijing is known, had become the most productive research arm in the Microsoft system “in terms of the quality of the ideas that they are turning out. It is mind-blowing.”” and “In China today, Bill Gates is Britney Spears. In America today, Britney Spears is Britney Spears – and that is our problem.” The Chinese is catching up, and catching up quick.
Nonetheless, given that China today is still a very cyclical economy, there will be times when Chinese stocks will be severely overvalued and severely undervalued. On an individual stocks basis, many more companies will go out of business in China (as a proportion of the total number of companies in China) than here in the U.S. The duty of MarketThoughts.com when it comes to China is thus two-fold: to help our subscribers successfully navigate the cyclical nature of the Chinese market and to help pick out the companies that will be successful in the long run – or, at the very least, to avoid the losers. Given our study of emerging markets and of world economic history and of social/technology trends, I believe we are primed for this challenge (heck, havings contacts in Hong Kong and in China don't hurt either). In fact, as I will show you in our following paragraphs, the Dow Theory is all the more important given that we are now getting increasingly globalized and that information is continuing to be more readily available.
But what if I don't want to invest in China? What if I want to invest in U.S. equities only?
Like I mentioned previously, the United States stock market today is becoming a market where “market efficiency” is getting increasingly more prevalent. Excess returns are becoming more difficult to capture over the long-run, especially with over 10,000 hedge funds on the sidelines waiting to pounce on any money-marketing opportunity.
Readers may recall what I wrote in my “On Jesse Livermore And His Legacy” article – on how Jesse Livermore was able to succeed mainly because of his ability to continuously evolve his trading and investing style in tune with the markets. What ultimately undid Livermore in the early 1930s was his failure to evolve with the anti-free-markets economic policies of Franklin Roosevelt and his group of “brain-trust” academics. Recall what I said in Lesson Three and our conclusion from that commentary: The idea of evolution in the stock market continues to hold true today. In fact, with the advent of globalization and information technology, it is now even more imperative to evolve since trends can change much more quickly. Information is now instantaneous. Investors will need to be more nimble. Whereas Philip Fisher emphasized that timing was not too essential in the purchase of stocks in 1958, this has all changed today. Witness the meteoric rise and fall of Taser – all in a short time span of 12 months! Also witness the huge amount of cash that has been sitting on the balance sheet of Warren Buffett's Berkshire Hathaway over the last 24 months. Yes, the company has grown bigger, but as a percentage of total net worth, the amount of cash that Warren Buffett is currently holding is unprecedented. Ten years ago, Buffett would have been able to find opportunities to put this cash to work. Buffett had always been a great timer in the stock market (he had always had the great ability to evolve), and I believe he will be putting all his cash to work once he finds the best time to buy equities, bonds or whole companies. In a weird way, Livermore's trading/timing strategies may have been revived. The point is: Today, the timing of the stock market and individual stocks is all the more essential. And MarketThoughts.com is here to help. While the analyses of individual stocks and industries continues to be important today (and sites such as the Motley Fool does a good job of it), we also believe that the ability to time the stock market on at least the intermediate-term basis (and the ability to adapt to a different style of trading and to recognize which asset class to buy) is going to become more essential down the road. Through our twice-a-week commentaries and our DJIA Timing System, we will seek to complement our analyses of businesses, individual stocks and industries, with our proprietary technical indicators and our timing skills in the stock market.
This is no easy feat, but wait; there is one Theory that has managed to withstand the test of time through over a hundred years of usage in timing the stock market. This is the Dow Theory. The Dow Theory has withstood the test of time mainly because of the fact that it is a Theory based on a series of essays and editorials written by Charles Dow, the founder of the Wall Street Journal at the turn of the 20th century. It is not a “system” nor a set of formulas – it is strictly a theory based on valuations and the idea of a primary trend – with the rest open to interpretation by the students of the Dow Theory. When push comes to shove, students of the Dow Theory are as much as contrarians as they are trend-followers. Consider the following quote from one of Charles Dow's original editorials: “The first thing for any operator to consider is the value of the stock in which he proposes to trade. The second is to determine the direction of the main movement of prices.” In today's environment – in order to buy values – one will need to be a contrarian – whether it is a play in the overall stock market or more likely, in a particular industry or particular individual stock. For example, I have previously quoted Merck (MRK) as one of the better long-term plays currently out there, and I still stand by my position. Does anyone recall the liability problems that Phillip Morris (now Altria Group) supposedly had slightly over five years ago and how they were going to bankrupt the company? Well, the company survived and continued to reward its shareholders, and today, the company still has one of the highest dividend payout ratio out of the 30 Dow Jones Industrial Average companies despite rising nearly 250% from its low in early 2000. Using a similar line of thinking, I believe Merck is now undervalued – it is a great company and as long as it survives (which I definitely think it will), it will continue to prosper going forward.
As for whether the Dow Jones Industrial Average and the Dow Jones Transportation Average are good barometers of the U.S. economy, I have argued many times before that they are still very good barometers, especially given we are now in a globalized world since so many of these firms in these two stock market averages have global operations. Ladies and gentlemen, the usefulness of these two popular Dow Indices have been questioned many times before in the past 100 years, and they are still being questioned as I am typing this. For readers who are interested, you can read my latest argument for the Dow Theory in our discussion forum, as well as share your thoughts on the Theory on our Dow Theory Board.
I will continue to discuss the usefulness of the Dow Theory in our continually globalized world as we go forward in our investing journey – and to also take it to the next level and evolve it as I continue the quest to take and transition the Dow Theory to the 21st century. Past Dow Theorists like William Hamilton, Robert Rhea, and E. George Schaefer have successfully evolved the Dow Theory to achieve many profitable timing and investing opportunities, and I believe this will be essential as the world is continuing to change at an ever-increasing pace. The advent of globalization and the “flattening” (as described by Thomas Friedman) of our world will level the playing field as well as empower the individual. What this means is that successful investing or timing does not merely involve clicking on the IBD website and seeing what is on the Top 100 list anymore – perhaps that used to be the case when IBD was not well-known or when one only had access to paper copies and checking stock quotes or constructing charts was a burden. Today, one needs to be much harder-working than that, and also to be a contrarian. In a way, the proliferation of the internet has made investing successfully much harder than it used to (the arbitrage plays that Warren Buffett did even in the 1980s do not work anymore), but armed with the Dow Theory and over a hundred years of history of both data and how the Dow Theory has evolved over time, I believe we will be able to help our subscribers immensely going forward in the 21st century. Make no mistake: I intend this to be the home of the Dow Theory in the 21st century.
But wait, there is still more. As an aside, I believe the foundation for the collapse of the Manchu Empire can probably be a great business case study. Lesson: Don't let this happen to your country! To those who are interested, I will quote from that very same article on the Qian Long Emperor: “In his later years, Qian Long was rather disillusioned and sedated with power and glory. With He Shen as the highest ranked minister and most favoured by Qian Long at the time, the day to day governance of the country was left in the hands of He Shen whilst Qian Long himself indulged on everyday luxuries and his favourite pastime of hunting. It is widely said that He Shen laid the foundation for further collapse and corruption of the Qing government and eventually came to a point where it was impossible to reverse the negative impact already done to all levels of Qing Government at the time. Worse still, the proposed cultural exchange between the British Empire at the time and the Qing Empire collapsed when He Shen further encouraged Qian Long to maintain the belief that the Qing Empire was the centre of the world and need not pay much attention to the British proposal for trade and cultural exchange. The British trade ambassador at the time was humiliated when granted an audience with the Qian Long Emperor only to find just an Imperial Edict placed on the Dragon Throne. This announced to him that the Qing Empire had no need for any goods and services that the British could provide and that the British should recognize that the Qing Empire was far greater.” Within days of Qian Long's death, He Shen was ordered to commit suicide by Qian Long's successor, the Jiaqing Emperor. Too little, too late.
Henry K. To, CFA