Dow Theory Explained and Bull Market Signal Questioned

By Victor Sperandeo with the Curmudgeon



Introduction (Curmudgeon):                                                                                                                                                                             

In my last Curmudgeon post, I failed to attribute the source of the April 1, 2019 Dow Theory bull market confirmation signal (which was a negation of the Dow Theory Sell Signal that was previously in force since December 2018 and had been reversed).  It was an email that same evening from the Aden Forecast, which had purchased Dow Theory Letters and thus was assumed to be the "guardians" of Dow Theory.

Matt Kerkhoff wrote in the March 2019 Aden Forecast:

In order for Dow Theory to turn bullish, we need to see the reaction rally come to an end (which it appears it recently has), followed by an attempt at new lows. If the attempt at new lows fails (the averages do not fall below their December 24th lows), and then both averages stage a rally and surpass their recent reaction rally highs (26,091.95 for the Industrials and 10,632.49 for Transports), that will trigger a Dow Theory bull signal.

In their April 1st email to subscribers, the Aden sisters said the above criteria had been met, which triggered a new Dow Theory Bull Market signal.  When I shared that information with Victor the next day, he disagreed.  Here is his assessment of where we are in Dow Theory:

Victor's Rebuttal to Aden Forecast Bull Market Call:

I have to professionally disagree with the Aden Forecast's Dow Theory Bull Market call.  Let's first recap the genesis and essence of Dow Theory to explain why.

The people who developed the Dow Theory were Charles Dow (founder of the Wall Street Journal), S.A.Nelson (via his book “The ABC of Stock Speculation” published in 1902), William Peter Hamilton (former editor of the Wall St Journal from 1907-1929), and Robert Rhea (a private investor who wrote and invested very successfully using Dow Theory).

Rhea was really the master writer/explainer on Dow Theory.  He wrote several books on the subject and a market letter every 10 days from 1932 to 1939, all of which I read and studied in 1970.  His classic “The Dow Theory” book was published in 1932.


The 2018 “Bear Market" classifications are clear to me:

The TOP for DJI was on 10/3/18 at 26,828.39; DJT on 9/14/18 at 11,570.84.                  

First Primary Down leg ended 10/29/18 with DJI = 24,442.92 (-8.89%); DJT on 10/29/18 at 9896.11 (-14.47%).

Secondary Correction rally was:  DJI on 11/8/18 at 26,191.22 (+73.3% of the decline); DJT on 12/3/18 at 10,850.44 (+57% of the decline).   [Typically, secondary corrections are usually 1/3 to 2/3’s of the previous moves.]  

As a general rule these ranges are "highly significant" statistical events when averaged, but with some exceptions.  I have concluded this after reviewing Rhea’s work (from 1896 -1939) and added my classifications from his death in 1939.

Second Primary Down leg ended on 12/24/18: DJI =21,792.20 (-16.8%) and DJT= 8,637.15 (-20.4%).

Secondary Correction rally as of 4/5/19: DJI=26,425 and DJT=10,734.30 (still below the last correction high of 10,850.44 on 12/3/18).

To be in a new Bull Market, which the Aden sisters are asserting, one must believe that a Secondary Correction DECLINE occurred from DJI= 26,091.95 on 2/25/19 to 25,473.23 (=-2.33% in 10 days) and DJT= 10,632.49 to 10,000.79 (=-5.95% in 32 days ). 

Since 1896 this type of "correction" has never occurred!  That's because the small declines during the above time periods were not significant!

Therefore, that market down move would be considered a “LINE” rather than a SECONDARY CORRECTION according to Rhea's interpretation.


Definitions from Rhea's “The Dow Theory” book [Unedited EXCERPTS]:

LINES:  a line is a price movement extending two to three weeks or longer, during which period the variation of both averages move within a range of approximately five percent.  Such a movement indicates either accumulation or distribution (ie.a consolidation).  Simultaneous advances above the limits of the line indicate higher prices (NOT A CHANGE OF THE PRIMARY TREND); conversely, simultaneous declines below the line imply lower prices....             

Both DJI and DJT averages must confirm.

SECONDARY REACTION (AKA a correction):  For the purpose of this discussion, a secondary reaction is considered to be an IMPORTANT DECLINE in a bull market or ADVANCE in a bear market, usually lasting from three weeks to as many months, during which interval(s) the price movement generally retraces 33 percent to 66 percent of the primary price change since termination of the last preceding secondary reaction.

These reactions are frequently ERRONEOUSLY assumed to represent a change of primary trend, because obviously the first stage of a bull market must always coincide with a movement which might have proved to have been merely a secondary reaction in a bear market. The contra being true after then peak has been attained in a bull market.”

The Relation of Volume to Price Movements:  A market which has been overbought becomes dull of rallies, and develops activity on declines; conversely, when a market is oversold, the tendency is to become dull on declines and active on rallies.


Kindly observe that the volume on the current upside breakout (confirmation?) was extremely light.  The average volume on the NYSE from 2/28/19 to 3/29/19 was only 1,034 million shares a day. 

Curmudgeon Note:  Indeed, this past week's U.S. stock market rally has come on decreasing volume:  On 4/1/19 it was only 833,841,727 shares and on Friday 4/5/19 it was 769,783,949 shares (vs. 1,083,007,757 shares one week earlier). 

Dow Theory vs. Global Central Banks:

The equity markets may continue to rally, but it would not be because a new Dow Theory “bull market" has started. Instead, it would be because the market has CHANGED.

That, in turn, is due to global Central Banks having over-stepped their twin mandates of price stability and (for the U.S. Fed) the promotion of maximum sustainable employment.  They now also focus on and target what they believe GDP growth SHOULD BE using Keynesian economic models.   They also seem to be protecting the stock market(s) from declines.  Such moral suasion and covert market intervention were started under Fed Chairman Alan Greenspan after the 1987 stock market crash. It became known as the "Greenspan put."

The market could continue to rally because a tenant of Dow Theory is “it is not infallible.” 

It appears that the bear market only occurred, as long as the Fed was raising rates.  That ended when the Fed flipped and stated they would stop Fed fund rate increases.  This comes under “the markets have changed” clause and is due to Central Bank Planning.

If we've had a Bear Market that ended, it was only 82 days long for the DJI? That would be unprecedented. 

The recent and ongoing stock market rally has not confirmed by closing above the previous secondary highs, which is a signal for “determining the trend” under Dow Theory.


New Era and Stock Market Disconnect Continues Unabated:

It also should be noted that Europe is under tremendous economic and political stress (and BREXIT is still undecided).  A few countries like Italy are in recession, but their markets have also risen for no obvious reasons. 

The whole world is in slowdown without any stimulus and yet the markets are strongly rallying.  Such is the new game of using beyond reason, but to maintain power serving the rich using the governments' printing presses.


Aden Sisters email reply to the Curmudgeon on April 5, 2019:

Thank you so much for sending us Victor's Dow Theory report. Yes, we don't agree.... but that happens fairly often when Dow Theory signals leave some wiggle room. In our last issue we laid out the exact reasons why we now believe a new bull signal was triggered and what to be watching for. The article was written by Matt Kerkhoff and all of the Dow Theory team agree with his bottom line. We will soon see if this proves to be correct or not...but so far, so good.

Thank you for bringing this analysis to our attention and wishing you the best,

Mary Anne & Pam


Curmudgeon on Trump vs the Fed, Weak Global Economy and U.S. Profits Recession: 

1.  We find it astonishing, that on the very same day the U.S. Labor Department reported strong job growth (with employers adding 196,000 jobs last month). President Trump called on the Federal Reserve to cut interest rates and begin another round of QE.

“Well I personally think the Fed should drop rates,” Mr. Trump said. “I think they really slowed us down. There’s no inflation. I would say in terms of quantitative tightening; it should actually now be quantitative easing. Very little if any inflation. And I think they should drop rates, and they should get rid of quantitative tightening. You would see a rocket ship. Despite that, we’re doing very well.”

Really?  The effects of the president’s $1.5 trillion tax cuts are waning, and the Trump trade war has begun to hurt some American industries, as well as contributing to slower growth in China.  Samsung this week said they expect a 70% decline in profits this quarter, partly due to weakness in China and reduced demand for memory chips. Most forecasters see U.S. economic growth slowing this year, though Mr. Trump’s economic advisers continue to see it speeding up.  If the President really believed that, why did he call for the Fed to ease monetary policy?

In our last Curmudgeon post (referenced in the Introduction above), we noted that Larry Kudlow had suggested the Fed cut rates by 50 bps after earlier stating that the U.S. economy was very strong. 

In a note to clients about that, Victor wrote: “The essence of political statements is to tell people what they want to hear to maintain confidence, i.e. to lie to keep the game going.”  We couldn’t agree more.

2.  The economic weakness Victor and I have been crowing about has started to be noticed and publicized in the mainstream media.  Today’s Financial Times (FT) has this lead story: Global economy enters ‘synchronised slowdown.’  Here’s an excerpt:

The global economy has entered a “synchronised slowdown” which may be difficult to reverse in 2019, according to the latest update of a tracking index compiled by the Brookings Institution think-tank and the Financial Times.

Sentiment indicators and economic data across advanced and emerging economies have been deteriorating since last autumn, suggesting fading momentum in global growth and the need to resort to new forms of economic stimulus.

The worsening outlook has sparked warnings from Christine Lagarde, managing director of the IMF, who said the fund would cut its growth forecasts later this week, and the World Trade Organization which has said the continued threats of trade skirmishes had weakened forecasts.

The findings follow generally disappointing economic indicators over the past six months that have shown a similar picture in the US, China and in Europe.

Professor Eswar Prasad of the Brookings Institution said all parts of the world economy were losing momentum.

“The nature of the slowdown has ominous portents for these economies over the next few years, especially given present constraints on macroeconomic policies that could stimulate growth,” he said.

The Brookings-FT Tracking Index for the Global Economic Recovery (Tiger) compares indicators of real activity, financial markets and investor confidence with their historical averages for the global economy and for individual countries.

The headline readings slipped back significantly at the end of last year and are at their lowest levels for both advanced and emerging economies since 2016, the year of the weakest global economic performance since the financial crisis.  The index fell partly because hard data indicating real economic activity has been weaker, with countries such as Italy falling into recession and Germany narrowly avoiding one and with the US economy losing steam as the effects of Donald Trump’s tax cuts wear off.

3.  We’ve also talked of a “profits recession” for quite some time and today’s WSJ echoes that warning in an article titled “Corporate Profit Squeeze Looms, Threatening Stocks’ Climb.  Excerpts:

Dozens of companies have slashed their profit forecasts for the first quarter…..With earnings season kicking off in earnest this week and valuations creeping up to their highest levels in more than half a year, investors say they plan to scrutinize corporate executives’ comments to gauge whether the contraction in corporate profit growth is a momentary blip or further evidence of a late-cycle economic slowdown.

Mike Wilson, chief equity strategist at Morgan Stanley said: “There’s a big risk to profit margins and quality of earnings we see this month and it’s definitely not priced into the market.”

Analysts estimate S&P 500 profits in the first quarter contracted 4.2% from a year earlier, according to FactSet. They expect that will be followed by no growth in the second quarter. That puts the broad index at risk of entering its first earnings recession—marked by at least two or more consecutive quarters of declining earnings—since 2016.

Companies that miss earnings estimates could respond by cutting spending on capital improvements and labor, further strangling economic growth and reigniting a stock-market selloff, Mr. Wilson warned, adding that earnings misses tend to force companies to rethink their priorities.

Russ Koesterich, a portfolio manager at BlackRock Inc.’s global allocation team told the WSJ:

“Companies are finding themselves more pressured on margins. Even if the economy chugs along and the Fed remains on hold, a greater-than-expected deceleration in earnings wouldn’t bode well for stocks. The question is whether the market has discounted enough the impact of slowing growth and some margin pressure on earnings.”

In closing, we are somewhat encouraged that the main stream media is at long last picking up on our risk aware messages to Curmudgeon readers. 

However, we wonder if anyone will pay attention?  At some point, the huge disconnect between the stock market and real economy will end.  Are readers prepared?


End Quote:

A man who was brilliant in understanding the nature of mankind espoused these soothsayer words:                                                                                                   

“A democracy cannot exist as a permanent form of government. It can only exist until the voters discover that they can vote themselves largesse from the public treasury. From that moment on, the majority always votes for the candidates promising the most benefits from the public treasury with the result that a democracy always collapses over loose fiscal policy, always followed by a dictatorship. The average age of the world's greatest civilizations has been 200 years. These nations have progressed through this sequence: From bondage to spiritual faith; From spiritual faith to great courage; From courage to liberty; From liberty to abundance; From abundance to selfishness; From selfishness to apathy; From apathy to dependence; From dependence back into bondage.”

― Alexander Fraser Tytler (1747-1813)


Good luck and till next time………………..

The Curmudgeon

Follow the Curmudgeon on Twitter @ajwdct247

Curmudgeon is a retired investment professional.  He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996.  He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.

Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies and government policies.  Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.

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