Wednesday, November 12, 2008

We can't afford a tomorrow like today

Inadvertently, as luck would have it, I chose a historic time to start a blog. In coming years, perhaps, it is not the election of a black man as an American president that will seem "historic." It might well be the economy. The CEO of Merrill Lynch comparing 2008 with 1929? General Motors near bankruptcy? Best Buy warning of "seismic" changes in consumer spending? All this in the midst of an unprecedented credit crisis, in the midst of sharply rising unemployment, in the midst of radically lower commodity prices and general deflation.

Never in my lifetime has so much so bad amassed so suddenly.

I am smart enough to know that NO ONE KNOWS what the stock market will do. No one. But, I have my favorites in terms of ways of looking at things. My favorite economic prognostication flavor is known as
Dow Theory.

As of today two particulars of Dow Theory are prominently in play. First, in a declining market the most recent lowest lows at the market close for the Dow (INDU) and the Dow Transportation Index ($TRAN) are important compasses of future direction. Second, if you take the highest closing high of the market and compare it with the lowest closing low of the market over a period of weeks or months or years you arrive at a number that is halfway between the high and low known as
the 50% Principle.

Now, don't go cross-eyed. Let me explain.


First of all, Dow Theory thinks the Dow Jones Industrial Average (even though it is only composed by 30 major corporations) is a pretty good indicator of how all of American business is doing.

Dow Theory thinks that the Dow Transportation Index is an important measure of how the economy is doing because it measures the profitability of goods (groceries, electronics, recreational stuff, etc.) moving around in the nation. If transportation companies are making money then people must be buying inventory thus forcing retailers to restock. Simple.

Now, let's go back to October 27, 2008. At the close of the market that day the Transports stood at 3364.98. That same day the Dow closed at 8175.77. These are the most recent lowest lows for both averages - so they are the yardstick for now.

Under Dow Theory, if either of these two indexes closes below its most recent low then you look for possible trouble. If BOTH indexes close below their most recent lows then whatever the recent economic picture has been will likely GET WORSE.

You got that? We don't want things to GET WORSE. They SUCK already.

Now, today the Dow closed decisively down over 400 points to 8282.66. The Transports closed down over 159 points to 3474.06. Those are both large declines almost 100 points away from breaking BOTH recent lows.

Ugly.

Thus, if tomorrow is like today things will likely get MUCH WORSE for the rest of 2008...according to Dow Theory.

How much worse? Well that's where the 50% Principle comes into play. The greater the distance in time between the high and the low, the more meaningful the mid-point can be. So, let's go back to when this great bull market started in 1982. The lowest low for the Dow in 1982 was around 776. Yes, that's 7-7-6. The highest high for the Dow was October 9, 2007 when the Dow closed at 14,164.53.

That is an astonishing 25 year period of primary growth. And the mid-point between the 1982 low and the 2007 high is 7470.

So what?

Well, *if* BOTH the Dow and Transports break to new lows in the coming days the next level we would look at from a Dow Theory standpoint is basically another 800 points below where we are today. And if the Dow fails to hold there...well then there's nothing under our feet. We could be looking at another market crash.

But, not so fast...

*If*, say, the Dow breaks to a new low but the Transports refuse and hold above their low then you have a Dow Non-Confirmation, that is the two key indexes fail to agree. It could indicate that the Bear Market doesn't have as much punch as some might fear and it could be a sign that we have reached a market bottom.

From a classic Dow Theory perspective nothing has been proven yet. There is the potential for a market bottom. There is the potential for a crash. Ain't market watching fun? What TV show gives you more uncertainty and thrills than the very real life difference between massive suffering and the next bull run?

Wait...there's just a bit more. You see, even Dow Theory gurus don't agree. I follow two prominent ones.
Richard Russell, who I've mentioned in previous posts, and Jack Schannep, who has written a new book on Dow Theory.

Jack thinks that today's declines placed us in a "second capitulation" for the market, meaning that the sellers are almost exhausted and the market has bottomed out. Jack uses a lot of quantitative analysis to arrive at his predictions.

Unfortunately, on October 7, 2008, Jack told his subscribers to move 25% of their cash back in to the market - which was at 9447.11. He called this the "first capitulation." Then, on October 15, 2008, he told subscribers to go another 25% into the market at 8577.91 - almost 900 points below his buy signal.

I didn't do that. So far, Jack looks kinda off his game. Well, after all, these are unusual times. Richard is more of a "classic" Dow Theorist. He was wrong back in the spring when he said the lows were in for the year and the bull market could be back.

It wasn't. Not yet anyway.

I am grateful to Richard for getting me into gold back in 2002. He is more of a long-term thinker. He is famous for calling the bottom of the great recession of 1974. So, I lean toward his guidance even though Jack has plenty of good information to help me make informed decisions as well.

Regardless of when the low is set, this is a terrific buying opportunity. The only problem is NO ONE KNOWS. So, we wait and see. Will the lows hold? If not how low will we go? If they do hold, however, Jack's advice of investing 50% of reserved cash could be great advice. There are definitely some values to be had in stocks these days.

I'm just not sure we have the "final" capitulation yet. But, I hope so. I'm just not putting any money on it yet.

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