Dow Theory: Yellow Flags or Green Light?

September 18, 2014

Mixed Message For Manufacturing

Stock prices have a high correlation to economic activity and earnings. History tells us bear markets are often kicked-off by recessions. Recent economic data does not hint at an imminent recession. However, a mixed message came in a September 15 report on industrial production. From The Wall Street Journal:

U.S. industrial production fell in August for the first time since January, the latest sign of uneven improvement in the economy…”The trend in the data still looks decent, but has moderated noticeably from the much stronger gains reported earlier this year,” said J.P. Morgan Chase economist Daniel Silver.

What Is Dow Theory?

Dow Theory’s stance has changed in the last 30 days; this article covers the recent improvement in the observable evidence. Before we cover the updated charts, it is important to revisit the fundamental concepts they convey. Dow Theory is based on a series of Wall Street Journal articles written by Charles Dow. The basic tenets are easy to understand. Charles Dow believed that:

  1. In order for industrial companies to increase their earnings, they had to produce and sell more goods.
  2. If industrial companies are selling more goods, then transportation companies must be delivering more goods to retailers and wholesalers.
  3. Therefore, in a healthy economy, both industrial companies and transportation companies should be experiencing revenue growth.
  4. If industrial and transportation companies are growing their revenues, then the industrial and transportation stocks should be attractive to investors.
  5. If industrial and transportation companies are doing well and are attractive to investors, both the Dow Jones Industrial Average and the Dow Jones Transportation Average should be making new highs in unison, serving to confirm a healthy economy.

Signal: That Was Then

If investors believe industrial and transportation stocks are healthy and thus, attractive investments, that speaks to demand. When demand is strong, stock prices rise. On September 2, the Dow Jones Industrial Average (DIA) was unable to post a new closing high, leaving an economic divergence in place relative to the high made in the Dow Jones Transportation Average (see charts below). The inability of the Dow to post a new closing high was an economic yellow flag according to Dow Theory (see point 5 in the list above).

Signal: This Is Now

In Wednesday’s session both the Dow Jones Industrial Average and the Dow Jones Transportation Average made new highs. Therefore, the concerning economic non-confirmation has been taken off the table.

How Can This Help Us?

Everything we do revolves around probabilities and an uncertain future. The new highs in the Dow and Trannies tell us investor confidence in earnings, economic activity, and Fed policy is better than it was a few weeks ago when the Dow was unable to sustain a new high. Sustainability is still important. If the new highs are followed by weakness and a retreat below 16,368 on the Dow, it brings us back into a lower investor conviction realm. The longer the Dow stays above 17,138, the better for the bulls from an “odds of good things happening” perspective.

Investment Implications – The Weight Of The Evidence

Have the observable evidence and hard data been helpful prior to and after Wednesday’s Fed statement? Yes, the S&P 500 (SPY) closed Monday at 1984, which was near a support level we noted last week. Our market model also told us to be patient heading into the Fed (see Monday tweet below).

Last week’s uncertainty called for a slight reduction in our equity exposure. We headed into the week with U.S. stocks (VTI), leading sectors, including transportation (IYT), offset by a relatively small stake in bonds (TLT). If the S&P 500 can post a new closing high Thursday (above 2007), then the evidence may call for an “incremental add” to our equity-based holdings.

Bullish, But Highly Flexible

With the Fed on the verge of a policy shift, we will take nothing for granted. The markets will need to be monitored a bit more closely in the coming months. The evidence will guide us if we are willing to listen.

Traffic light image Lawrence Rayner via Flicker (altered).

Is A Big Move In Stocks Coming Soon?

September 16, 2014

It Can’t Hurt To Be Prepared

Regular readers know we make decisions based on hard evidence from the markets, rather than attempting to forecast what will happen next. Therefore, we will be prepared for bullish, bearish, and sideways outcomes with a Fed meeting on tap this week. The market is telling us to be prepared for a big move (up or down) based on the current look of the charts.

Big Moves Can Follow This Look

The 50-day moving average helps filter out day-to-day volatility in the markets, allowing us to focus on the intermediate-term trend. When the slope of the 50-day starts to flatten out, it tells us the battle between the bulls and bears is relatively even from an intermediate-term perspective. An even battle speaks to indecisiveness about all the fundamental drivers, including:

  1. Fed policy
  2. Earnings
  3. Valuations
  4. Geopolitical risks

Once the market makes up its mind, big moves in stock prices often follow. The chart of the S&P 500 from 2006 below shows two examples.

How Do The Markets Look Today?

Since a picture is worth a thousand words, we will let the markets do the talking below. The 50-day moving averages are shown in blue.

German Stocks Have Work To Do

The German DAX (EWG) is highly correlated to the S&P 500, meaning they tend to zig and zag in unison for the most part. In the chart below, notice how the DAX dropped significantly from “a flat 50-day” look near point A. The present day slope remains concerning near point B. The bulls prefer to see the DAX’s 50-day turn back up.

Broader Market Looks Tired

The longer the NYSE Composite Index stays below the 50-day, and the longer the slope of the 50-day is negative, the more concerning it becomes for equities in general. Our concerns would begin to subside if price can push back above the 50-day and the slope can turn back up.

Dow Is Also Saying Pay Closer Attention

The 50-day can’t get much flatter or indecisive on the Dow (DIA), which is not surprising given the uncertainty with the Fed, interest rates, inflation, and the economy.

Investment Implications – The Weight Of The Evidence

The moral of the story? It is prudent to have a “stocks surprise on the upside” game plan in place, along with “stocks sell-off hard” contingency plans. In terms of execution, monitoring market levels is one method. For example, in the S&P 500’s chart below we will try to exercise some patience with our stock positions (VOO) as long as the S&P 500 remains above its 50-day moving average (near 1972). Even during the weakest part of Tuesday’s session, the S&P 500 was still trading at a “remain calm” 1979.

From a bullish perspective, if the S&P 500 (SPY) can close above 1991 and then 1997, we would be more open to adding to our stock holdings.

We will monitor the situation with an open mind and make changes if needed based on the hard and observable evidence, which is in stark contrast to a “forecast and hope” strategy.

Fed: The Key Portion Of This Week’s Statement

September 15, 2014

Yellen Looking For Consensus

Like Ben Bernanke, Janet Yellen appears to be a leader in search of consensus. After artificially holding down interest rates and pumping gobs of money into the financial system, the Fed faces the near-impossible task of trying to keep the financial markets fairly tame during a shift in interest rate policy. From The Wall Street Journal:

If the central bank moves too soon to raise interest rates, it could choke off the recovery. But if it waits too long, it risks encouraging too much inflation or otherwise becoming a source of financial instability. Some of the Fed’s strongest critics say it has already waited too long.

The Key Fed Passage

The passage below, from the Fed’s July FOMC statement, is what is referred to as guidance. This Wednesday at 2:00 p.m. EDT the market will be looking for possible changes to the two most important words below: “considerable time”.

The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.

The probability of a bullish reaction to this week’s Fed statement will increase if the passage above is not changed in a meaningful manner this week. Conversely, the probability of a bearish reaction will increase if the passage above is altered in a way that hints at “a rate hike is coming relatively soon”.

Pros And Cons Before The Fed

Since it is the market’s reaction to Wednesday’s Fed statement that matters most, it is prudent to review both the bullish and bearish cases before the fun begins. This week’s stock market video looks at cracks, concerns, and support.

After you click play, use the button in the lower-right corner of the video player to view in full-screen mode. Hit Esc to exit full-screen mode.

Video


Video

Investment Implications – The Weight Of The Evidence

Following Wednesday’s Fed festivities, if the S&P 500 can close above 1998, that would be a good step for the economic and stock market bulls. Conversely, if the S&P 500 finishes Wednesday’s session below 1984, concerns would remain about the possibility of further downside in equity prices.

Our market model saw enough deterioration last week to call for an incremental reduction in our exposure to stocks (SPY) and bonds (TLT). We still own stocks and bonds; just less than we did last Thursday. The flat 50-day moving average in the S&P 500’s chart above tells us the market is in an indecisive state. It is not uncommon to see big moves (up or down) from a “flat 50-day” look. Therefore, we will maintain a highly unbiased and flexible stance this week. The market will guide us if we are willing to listen.

Key image from Jake Liefer (creative commons).

Video: Cracks, Concerns, & Support

September 12, 2014

This week’s video should be available on the CCM Channel on YouTube Friday night.

Most Recent Comments Via Twitter

September 12, 2014

You can access them here (@CiovaccoCapital). You do not need to know anything about Twitter to view our comments or use the links to view charts.

Want To Reduce Investment Stress?

September 11, 2014

151 Point Energy-Sapping Move

If we told you the S&P 500 had moved 151 points since August 24, you would probably say, “you are crazy”. The S&P 500 closed at 1998 on August 25. The close on September 11 was just one point lower (1997). While the market has made little progress (up or down) since August 25, those who have been watching it tick-by-tick have gone on a 151 point energy-sapping and stress-inducing roller coaster ride. The table below shows the intraday swings on the S&P 500 dating back to August 25. The total of the intraday ups and downs comes to 151 points.

Focus On Closing Prices

For investors, watching the market tick-by-tick is often an unnecessary exercise. The real information concerning the net outcome between the bulls and bears comes in the form of the closing price. The same concepts apply to a weekly timeframe; the weekly close is often quite different than the stress-inducing swings that take place during the week. Are there exceptions to these rules of thumb? Yes, crisis periods require a bit more monitoring and focus (see 2008).

Focus On Support And Resistance

One way to reduce stress is to say, “I will leave my portfolio alone as long as the market closes above support”. This week is a good example. We have noted reasons to be patient on September 8, September 9, and September 10. As of the close on September 11, the support levels we have been watching remain in play, meaning we have remained in “leave it alone” territory during the recent intraday swings (see chart below).

Investment Implications – The Weight Of The Evidence

The tweet below from Thursday’s trading session sums up the “when a market is in a range” strategy:

The reference to organization above really speaks to the stress-reducing benefits of systems, rules, and structure.

Friday Is A New Day

Retail sales, consumer sentiment, and business inventories are all on deck. For now, we continue to hold U.S. stocks (SPY), a small stake in bonds (TLT), and leading sectors, such as technology (XLK). Even with the intraday rally Thursday, the S&P 500 is still down 10 points this week. If the bears carry the day Friday, our model may call for an incremental reduction to the growth side of our portfolios. As you might guess, we won’t consider anything firmly until the market nears the close.

Stress image from Steve Snodgrass via Flickr creative commons.

Gold or Stocks?

September 10, 2014

We All Have Limited Capital

Since all investment decisions involve opportunity costs, comparing alternatives head-to-head can help with the development of a short list of buy candidates.

Gold vs. S&P 500

The chart below shows the performance of gold (GLD) relative to the S&P 500 (SPY). When the ratio is falling, as it is now, it tells us gold is underperforming stocks. The ratio continues to make a series of lower highs and lower lows, meaning from an “odds perspective” we prefer to own stocks rather than gold.

Fed And The Yellow Metal

As we noted on September 9, many assets are impacted by the actions of the Fed and movements in the currency markets; gold is no exception. If the Fed raises rates, it tends to be U.S. dollar-friendly. If the dollar is strengthening, then the desire to own currency hedges, such as gold, starts to drop. From Forbes:

Tepid short covering is seen in Comex gold futures after the market hit a three-month low Tuesday. The market place is calmer so far this week, due in part to no major world economic data having been released. Traders and investors are already looking ahead to next week’s U.S. FOMC monetary policy meeting. Things are also quieter on the geopolitical front this week. The Russia-Ukraine cease-fire is holding up.

Investment Implications – The Weight Of The Evidence

Following the September 9 close, we penned the following:

On Tuesday, the S&P 500 closed inside the support band shown in the chart below (1984 to 1991). Therefore, it is too early to get overly concerned about recent weakness in equities. The blue trendline in the chart below has acted as support on numerous occasions (see green arrows). The S&P 500 bounced near the blue trendline Tuesday (see orange arrow), meaning buyers stepped in at a logical level.

Below is an updated version of the chart shown on September 9. During Wednesday’s session, the S&P 500 once again bounced off the blue trendline, telling us to exercise some patience with our positions in U.S. stocks (SPY) and leading sectors, such as technology (XLK). With two trading days left in the weekly bull/bear battle, we will enter Thursday’s session with a flexible and open mind.

Gold coin image from Evan Bench via Flickr creative commons.

Dollar May Drag Down Emerging Markets

September 9, 2014

Countless Moving Parts

One factor that makes investing such a difficult task is the almost infinite number of inputs impacting the value of any asset. For example, emerging market stocks could be negatively impacted by economic divergences between the United States and Europe. How can that be?

  1. Strength in the U.S economy may cause the Federal Reserve to raise interest rates in 2015.
  2. Higher rates in the U.S. make the U.S. dollar more attractive relative to the euro.
  3. Emerging market stocks tend to be negatively correlated to the U.S. dollar, meaning when the dollar strengthens, emerging markets tend to experience a currency headwind.

Fed May Raise Rates In 2015

Although economic data has been mixed recently, the trend has been improving over the last year. From Reuters:

Better U.S. economic data has boosted the view the Fed may be closer to raising rates, and the dollar’s gains have come at the same time as rising Treasury yields. Still continuing slack in the labor market is also viewed as keeping the Fed on hold for several more quarters. “People are more confident that the Fed is reaching its objectives,” Chandler said. He added, however, that “while the economy is healing, it’s not healthy.”

ECB vs. Fed

While the Fed is expected to rein in monetary policy in the coming months, the European Central Bank (ECB) has indicated a bias towards increasing their stimulative efforts. The diverging paths between the central banks are having an impact on the currency markets. From Reuters:

The dollar hit a 14-month peak against the euro on Tuesday, on optimism the U.S. economy is growing in line with expectations that the Federal Reserve may begin raising interest rates next year.

Investment Implications – The Weight Of The Evidence

On Tuesday, the S&P 500 closed inside the support band shown in the chart below (1984 to 1991). Therefore, it is too early to get overly concerned about recent weakness in equities. The blue trendline in the chart below has acted as support on numerous occasions (see green arrows). The S&P 500 bounced near the blue trendline Tuesday (see orange arrow), meaning buyers stepped in at a logical level.

As noted via the tweet below, the chart above can be used in conjunction with other levels of possible support for the S&P 500.

Our concerns would increase with each level taken out. If support holds, we will err on the side of doing nothing in the short run. If support breaks, we will review the evidence and make any necessary adjustments to our allocations. For now, we continue to hold U.S. stocks (SPY), leading sectors (XLV), and a stake in U.S. Treasuries (TLT). We will enter Wednesday’s session with a flexible and open mind.

Image from Barta IV via Flicker (proportions altered).

Energy: A Double-Edged Sword For Markets

September 8, 2014

Light Economic Calendar

With little in the way of market moving announcements Monday, traders tended to focus on changes in the energy markets. From The Wall Street Journal:

Oil futures shed 0.7% to $92.66 a barrel, their lowest price since January, amid concerns that demand isn’t keeping pace with booming supply. The pullback knocked shares of energy companies.

Late in Monday’s session, the Energy Select Sector SPDR ETF (XLE) was down 1.51%. Energy recently completed all three steps for a change in trend. A good baby step for XLE would be to retake $99.00.

Are Equity Red Flags Starting To Wave?

In order to gain a better understanding of the current investment landscape, this week’s video compares 2014 to 1987, 1998, 2002, 2003, 2008, and 2009.

After you click play, use the button in the lower-right corner of the video player to view in full-screen mode. Hit Esc to exit full-screen mode.

Video

Video

Doubled-Edged Sword

Lower oil prices can be good news for consumers. However, if oil prices remain depressed it eventually starts to impact the earnings of energy companies. News out of China contributed to oil’s pullback Monday. From Reuters:

China’s import growth unexpectedly fell for the second consecutive month in August, posting its worst performance in over a year and stoking speculation about whether authorities should loosen policy further to revive domestic demand.

Investment Implications – The Weight Of The Evidence

Monday’s session did little to impact the intermediate-term outlook for stocks. Therefore, we continue to hold an equity-heavy portfolio with U.S. stocks (SPY), leading sectors (XLK), along with a relatively small stake in U.S. Treasuries (TLT). Stock market bears would prefer to see a push below 1985 on the S&P 500.

Red Flags For Stocks?

September 6, 2014

After you click play, use the button in the lower-right corner of the video player to view in full-screen mode. Hit Esc to exit full-screen mode.

Video


Video


Still Relevant Big Picture Risk Management Articles - Weekend Reading.
More links and charts on Twitter.