Tuesday, August 28, 2012

Dow Theory: A Political Perspective

"There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of the voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved." - Ludwig von Mises

The validity of this basic tenet of the Austrian School of Economics will now be tested. The von Mises position stands at odds with the far more widely accepted Keynesian Economics view of the world, as I have mentioned before. To the extent that great economic theories are being contested this is an interesting time to be alive. To the extent that von Mises might be correct it does not bode well for avoiding economic pain ahead.

Long-time readers know of my interest in Dow Theory, which has nothing to do with the Austrian School per se. The oldest stock market timing method, pioneered by Charles Dow himself, has come under criticism in recent time. Some feel the relatively simple approach to the markets is now outmoded.

I disagree, though I admit there are other methods such as technical analysis, Elliott Wave Theory, etc. that have some validity. Dow Theory has served me best since I discovered it back in 2001 when I was losing money and didn't know why after doing so well in the late-1990's.

A quick review of a basic Dow Theory teaching: If both the Dow Industrials and the Dow Transports averages close above their most recent highest high (time period could be months or years) or, conversely, if the both close below their most recent lowest low, then this signals a Bull or, in the latter case, a Bear primary market trend. If, on the other hand, one average closes above the high or below the low but the other average (it doesn't matter which one) does not follow suit in a brief span of days or weeks then this is called a Dow Theory non-confirmation.

Confirmation signals validate the primary trend. Non-confirmations usually mean caution or pay attention, because the primary trend is subject to change. No matter how long it takes, Bulls are always followed by Bears which are, in turn, followed by Bulls. Dow Theory sees this and has a long history of measuring it. There is, of course, more to Dow Theory (but not a huge amount more, there are only a handful of overarching tenets like confirmation) but this one aspect is sufficient for where we are today.

On August 17 the Dow average closed near its most recent highest high, which it recorded back in May. It did so by shooting up some 20 points in the last hour of trading before backing off six points at the close. This placed it four points below the most recent highest high in May. In other words, if the Dow had closed 10 minutes earlier it would have closed at a new most recent highest high.

But, "close" does not count in Dow Theory. Everything is valid based only on how stocks close at the end of the day. (English is strange, note the spelling of "close" in the very different words of the last two sentences.) So, there was no potential confirmation signal given on that Friday. Meanwhile, the Transports closed up but still 50-odd points away from their May peak. If the Dow could manage the last few points and if the Transports followed suit then that would have been a Dow Theory Bull signal.

Since then, however, both the Dow and the Transports have retreated. Nothing has been decided except the markets are overbought and won't break to new highs this time. Of course, eventually, there will be another run up. The question is how far will the two averages retreat from their recent flirt with new highs before making another attempt at rallying. Until then, things are just kind of meandering along caught in a trading range.

The current primary trend is Bearish. Though not all Dow Theorists agree on this, the theorist I have followed most since 2001 is 88-year-old Richard Russell who says the trend is Bearish until the markets exceed their May highs. A Bull Signal failure would be indicative of a belief by the markets in continued sluggish economic times ahead.

My feeling is that this failure to change the primary trend from Bear to Bull is symptomatic of, frankly, rather disturbing undertones of the economy. Barring further government stimulus stocks have topped out for now. Most people don't realize how bad the economic situation is. This grey-toned economy could last for many years. We are choking on both public and private debt. Employment will likely remain sluggish or worse. Consumer confidence is at a 9-month low. We are confronted with a "fiscal cliff." Europe is already in a new recession. The Federal Reserve is seriously considering intervening yet again to prop up the economy.

Intervention by the Fed will not work any better now than the first two times it was attempted. The Bear must be allowed to fully express itself. This is the fundamental meaning of the von Mises quote at the beginning of this post. The current economic recovery after the Great Recession has been anemic. Some think we might still be in a recession. I don't know about that but I do know that unemployment remains at a point where historically US Presidents do not get re-elected.

The election is extremely close right now. A few swing-states will probably decide the whole thing between Barack Obama and Mitt Romney. The economy will trump all issues as usual. Gay marriage, abortion rights, and Obamacare are not going to be the driving issues, though they will certainly color things and you cannot discount such secondary issues when the election seems anybody's to lose.

Since the economy tops every other issue, I am paying especial attention to Dow Theory right now. It has the dual significance indicating how the economy and, in turn, the presidential election will most likely go. Most economists seem to think the Federal Reserve will not launch QE3. As of today, nothing of conviction has been established about our close proximity to a Bull Signal. It could be that the Dow is simply overbought right now and is just building support for a higher rally.

I find it hard to believe that this will happen but, according to Dow Theory, we are (or were) on the verge of a Bullish near future. Of course, that would be great for Obama and, of course, Romney does not want to see the possible Dow Theory confirmation, even though neither candidate probably thinks about it in those terms at all. But Dow Theory is fundamentally about timing the market. You invest with the Bull. You remain skid-dish or in cash with the Bear. The Bull helps Obama. The Bear helps Romney.

Last week Romney might have made the most serious mistake of his campaign. He stated that he had no intention of renominating Federal Reserve Chairman Ben Bernanke for another term (his current term ends in 2014). Now the question becomes, how much does Bernanke want to hang on to his job?

The Federal Reserve is an unconstitutional entity. I believe all central banks should be abolished. But this is not a post about political truth. It is about political reality, which is rarely the same thing. The reality is that there is no more powerful economic person on the face of the Earth than the Federal Reserve Chairman of the United States of America.

So, Romney has (unwisely in my opinion) stated to the world that he wants to fill the expanse of such power with someone else. This has given Obama a possible opening. If Bernanke wants to keep his job then he obviously wants Obama over Romney. If the economy can be propped up well enough then Obama will likely get re-elected.

By a slim margin, most analysts think QE3 is not a foregone conclusion. Bernanke realizes that another round of quantitative easing might not work. Bernanke is not an avid Obama supporter. He is, rather, an advocate for the integrity of the Federal Reserve itself. If the Fed embarks on QE3 and it fails to yield positive results, then the Fed has suddenly lost an enormous amount of its perceived power. That, perhaps, is ultimately more important to Bernanke than his own reappointment.

Romney says he wants a strong dollar. I guess almost every presidential candidate has postured himself thusly. The problem is that a strong dollar is the last thing we need. The stronger the dollar the greater the debt feels. It is only by weakening the dollar that we can avoid deflation, which also increases the effects of the debt. So Romney is flat-out wrong.

This does not make Bernanke right, however. The ideology behind QE-whatever is equally flawed. It will not work. Nevertheless, contrary to the majority of wise economists, I think the Fed will step in at some point, probably in September. The stock market will likely rally, perhaps even to the point of giving a new Dow Theory Bull Signal. This will be an artificial stimulus but it will be a rally nonetheless.

Ironically, the people most likely to profit from QE3 are all on Wall Street, one place that hates Obama most. The rally that could come and possibly give Obama the re-election will sucker-in many investors who will probably lose money as Wall Street profits upon the event that could give the president they hate four more years in office.

Another consequence of QE3 is that it should send my primary investment upward. Gold will rise as the dollar is devalued. If the economy isn't going to grow (which it isn't) then the only other way to deal with the weight of the US debt (which is growing at an unsustainable pace) is to devalue the dollar. That makes the debt feel cheaper but it simultaneously threatens the currency system, as von Mises predicted. Gold has recently moved up too far too fast, however, and is now overbought. I will likely add to my position (or perhaps even add to my Silver position) with the next pull-back.

Everything I have just written, of course, seems like a tangled web of almost contradictory occurrences. There is very little clarity ahead.  Still, I will attempt to make money off this situation though, in the end, none of it will make the least bit of difference to the US economy. The Bear will have his say - otherwise von Mises is wrong about the ultimate consequence of massive and extended credit booms such as what we have experienced in the last 40 years and their inevitable effect on the currency system which supported the booms in the first place.

Late note: Friday, August 31 - Fed Chairman Bernanke delivered what the NY Times called "a detailed and forceful argument for new steps to stimulate the economy" today.  This sent the stock markets and gold higher.  No specific policy was mentioned, however.  So, now we wait until September to see if QE3 actually happens.  Again, I wonder if Bernanke wants to keep his job under a re-elected Obama as opposed to lose it under a newly elected Romney.  As if to reinforce the political nature of this matter, the Romney camp reacted negatively to the Bernanke statement.

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