What a hit the Dow took on Friday. A 530-point fall.
Any guesses for what direction our market heads today?
The US share market is officially in correction mode…a fall of 10% or more.
No doubt the buy-the-dip brigade will convince enough punters to load up on the supposed discounts on offer and temporarily reverse the trend. Markets rarely rise or fall in a straight line, so a bounce is all but assured.
But underneath the glitz and glamour of Wall Street is the reality of what’s happening in the global economy.
A 100-year old theory has once again been signalling all is not well.
How does ore get to China? How do all those electronic goods get onto the floor of Harvey Norman? How did all those foreign cars get into the dealer’s showroom? How do all those business people and travellers move from city to city? How does the wool from the sheep’s back end up as a pullover on your back?
Most of us do not really ponder these questions too deeply. The answers are all too obvious — planes, trains, automobiles and ships. So what’s the big deal?
The movement of commodities, goods and people are an indication of economic activity.
During the GFC, ships stayed anchored because banks did not trust each other’s credit. Would you transport millions of dollars of cargo if you knew there was a serious question mark over payment? Not likely. Transportation makes the world go round. The health of the transport sector is a time honoured indicator of what’s happening in the real world.
The Dow Theory, established over a century ago by Charles Dow, was based around splitting industrial shares (Dow Jones Industrial index) and transport shares (Dow Transportation Index) into these two separate averages.
The logic behind this theory is simple. Industrial companies produce things that are transported around the nation and world. Even tech companies like Apple must ship their laptops, phones and watches to their retail stores.
According to the theory, movements on one average must be confirmed by the other.
Under Dow theory a major change in trend from a bear to a bull market (or vice versa) cannot be confirmed unless both these averages are in agreement.
The Dow Transportation Index (DJT) contains major shipping companies, railroads and air freight carriers Companies such as Avis, Delta Airlines, FedEx and United Parcel Service (UPS).
At major turning points in the recent history of the US share market, the DJT has been the canary in the mine.
During the dotcom boom the DJT topped out in May 1999. The Dow Jones Industrial index continued on its merry way for several more months. However in early 2000, the Dow Jones Industrial index confirmed what the Transport index signalled eight months prior. The Dow spent the next two years heading in a southerly direction.
In 2007, the DJT peaked in July. This was a full four months before the Dow Jones Industrial average (DJIA) decided the subprime lending debacle was going to be a bigger issue then Bernanke thought it would be.
The DJT reached a high of 9217 points on 29 December 2014. Since then it has been a downhill run, shedding over 1100 points.
Whereas the DJIA again ignored the DJT and went onto a high of 18,300 points on 20 May 2015. The Dow has fallen around 1,300 points over the past three months. In percentage terms, this around half the fall in the Transport Index.
The theory Charles Dow developed over a century ago, still appears just as relevant today.
The theory also included the phases that bull and bear markets go through on the way to their respective highs and lows.
Understanding the psychology driving market valuations can assist in staying ahead of the crowd. Appreciating what the herd may do next helps you keep your head while they lose theirs.
Predictably, the final phase of a bull market is excess.
Speculation is excessive. Confidence is excessive. Valuations are excessive. While the mood has turned a little sombre of late, it wasn’t that long ago these type of headlines were dominating the financial press:
‘Australian sharemarket hits new 7-year high, approaches 6000 points’
The Australian 20 March 2015
‘Dow: New high for second straight session’
USA Today 19 May 2015
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A few months ago when the RBA dropped interest rates, all the mainstream commentators waxed lyrical about the higher fully franked dividends on offer from quality shares. Cash was trash. Has that extra few percent of income been worth watching your capital shrink by more than 10%?
Money in the bank is still 100 cents on the dollar last time I looked.
Excessive noise about the share market’s powers to create riches tends to dominate the final phase of a bull market. Time and time again people forget or ignore: what goes up must come down.
The first phase of a bear market is distribution.
This is when we see the first murmurings of ‘something ain’t right’. The smart money understands the inhale and exhale process of the market. After six years of expansion, contraction was bound to follow. The smart money is usually in early and exits early. They’re happy to cash in some or all of their chips. During this phase average Joe and Josephine are still listening to those vested interest talking heads in the media telling them to buy, buy, buy. Cash is trash. Better returns are on offer from fully franked dividends, hybrid securities and property trusts.
The public are still be seduced by the offer of a few extra percent income and fail to recognise this is the tip of a capital destroying iceberg. What they don’t see, until it is too late, is the capital cost that lurks beneath.
During this phase the media dare not utter the term ‘bear market’. Normal trading conditions are going to resume anytime soon, so says the person wearing a ‘Trust me I’m from Wall Street’ cap.
And generally people tend to believe the message. They buy-the-dip. The market stops its slide and retraces some lost ground. ‘See I told you,’ says the person with the cap. However, watch and see if the buy-the-dip bounce sets a new high or not.
If it doesn’t, then the theory is it’s just a suckers rally. Setting investors up for phase two.
The second phase of a bear market is the big move.
Says it all really doesn’t it? The signs that spooked the smart money into selling, become painfully obvious to everyone. Business conditions deteriorate. Earnings fall. P/E ratios are reduced to reflect the uncertainty over future earnings. Bankruptcies increase. Debts are defaulted on.
This all creates a negative feedback loop. The big move downwards is on and hard to arrest.
Portfolios are awash in red ink. Investors are wondering if the losses will ever stop.
Just when you think the worst is over, along comes phase three.
Phase three of a bear market is — you guessed it, despair.
Hard to imagine the prevailing mood will be one of hopelessness.
But that is what happens. Investors doubt they will ever see a rising market ever again.
The Secular Bear market of 1968 to 1982 was so soul destroying, that in August 1979 BusinessWeek’s front cover proclaimed ‘The Death of Equities’. The article questioned whether share markets would ever again be a source of wealth creation. A little over three years later the greatest Secular Bull market in history began, but near its lowest point, very few had any faith in this being the eventual outcome.
Markets are bi-polar. They take you to the highest of highs and down to the lowest of lows. This is an established pattern. The Fed may want to keep the market on a perpetual high with an increased dosage of happy gas, but that is not natural.
At some point, and I think that point is coming real soon, the market develops total immunity to the Fed’s medication. The smart money knows this and my guess is phase one is already in play.
The big move and despair are what awaits those who do not take heed of what the Transportation Index is signalling.
Editor, Markets and Money, Australia