2023-03-26 14:45:24 ET
Summary
- We extend our analysis of US equities which integrates technical and fundamental analysis.
- Dow Theory provides some valuable insights and raises interesting questions in the current context.
- We explore two relatively unknown and unexplored principles of Dow Theory that analyze, in very different ways, the relationship of certain macro-economic fundamental trends with trends in price action.
In an article I published two weeks ago I pointed out that the US equity market is at a very critical juncture, both fundamentally and technically. If the S&P 500 index establishes a higher high within the uptrend that was established since the lows of October 2022 (represented by the green line), a new bull market will likely be confirmed. On the other hand, a violation of the 3764 level would represent a breakdown of the aforementioned up-trend and signal a likely resumption of the bear market downtrend that commenced in January of 2022 (red line).
In this article I will extend this analysis and highlight some of the factors that investors and traders should be looking for that can help them anticipate which of these two opposing paths the market is likely to take.
In particular, I am going to focus on some overlooked insights that are derived from Dow Theory that can help to frame a fruitful analysis.
Some Background on Dow Theory
To the extent that people today recognize the term “Dow Theory” at all, they will most likely associate it exclusively with a method of technical analysis. Indeed, the origins of most of modern technical analysis, including its myriad different “schools,” can be traced back to Dow Theory.
However, what is rarely recognized or understood – even by financial markets professionals - is that Dow Theory was originally conceived as a way to integrate the analysis of price action with the analysis macro-economic fundamentals. As it was originally conceived, the core premise of Dow Theory is that there is a discernible relationship between certain macroeconomic processes and price action in the stock market.
In this article I will focus on two aspects of this proposed relationship.
The Stages of Bull and Bear Markets are Driven by Cyclical Patterns in the Progression of Fundamentals
Dow Theory posits that price action in the US equity market exhibits cyclicality and that the major up-trends and down-trends within these cycles can be tied to specific patterns of progression in the evolution of macro-fundamentals and expectations regarding the evolution of these macro-fundamentals.
Dow Theory posits that a primary up-trend – popularly known as a Bull Market – can be divided into three stages. Similarly, Dow Theory posits that a primary down-trend – popularly known as a Bear Market – can be divided into three stages. In accordance with Dow Theory, the three stages of bull markets and bear markets are essentially mirror images of each other.
Of particular interest in the present context is the fact that Dow Theory explicitly recognizes that, in real-time, it is exceedingly difficult to distinguish between a “corrective” secondary trend (upward) within a bear market (popularly known as a “bear market rally”) and the initial stages of a new primary up-trend (i.e. “bull market”). In particular, after a rally off of a major bear market low, the first significant decline from a local peak can “feel” like it is a resumption of a bear market when it is actually just a “corrective” trend (secondary or minor) within a new bull market. Conversely, a decline from a local peak established after a major low is often incorrectly perceived to merely be a corrective movement within a new bull market when it actually constitutes a resumption of the primary bear market trend.
Dow Theory developed certain principles of technical analysis that were designed to help analysts distinguish between a mere bear market rally and the initial stage of a bull market. But in this section, I will highlight a key fundamental factor, that is integral to Dow Theory, which can help analysts make this critical distinction.
According to Dow Theory, the state of macro fundamentals is virtually indistinguishable between Stages Two and Three within a bear market and Stage One of a bull market. In Stage One of a bull market the state of macroeconomic fundamentals is generally poor and the state of business fundamentals (e.g. earnings, cash flow and health of balance sheet) is very bad. It is not until Stage Two of a bull market half-cycle that fundamentals have turned in an upward direction. In Stage Two, the economy is generally in the midst of a confirmed up-swing and, most importantly, corporate earnings have started to recover and are exhibiting positive growth. Indeed, by definition, the price action in Stage Two of a bull market, according to Dow Theory, is largely driven by a positive evolution in corporate fundamentals (e.g., positive growth in earnings and cash flow).
Stage Two of a bear market is the mirror image of Stage Two of a bull market. In Stage Two of a Bear Market, price action follows the actual downward trajectory of economic and corporate fundamentals. For example, prices fall as investors and traders react to news about a decline in corporate earnings.
It follows from the structure of this basic model that a new bull market trend is only likely to be sustained if corporate fundamentals are set to resume an upward trajectory on a sustained basis. If, to the contrary, corporate fundamentals are set to actually transition from a state of growth to a state of contraction, then it is likely that the market is actually in Stage Two (or even Stage Three) of a Bear Market.
In the context of a transition from positive earnings growth to negative earnings growth it is highly unlikely that any rally off of a bear market low will be confirmed as the start of a new primary bull market. Any rally off of a major low which coincides with a transition in corporate earnings from growth to contraction is likely to be merely a bear market rally – i.e a corrective secondary trend dividing Stage On and Stage 2 of a bear market.
In sum, in accordance with Dow Theory principles, the rally off of the October 2022 lows will likely be remembered, in retrospect, as a bear market rally (dividing Stage On and Stage Two of a bear market) if expectations regarding corporate earnings undergo a transition from the current general expectations for modest growth in 2023 to expectations of significant a contraction. Conversely, as long as expectations of corporate earnings remain positive or only modestly negative, a new leg down in the bear market – i.e a Stage Two of a bear market – is unlikely to materialize.
Prediction of Fundamental Trends via Fundamentally-Based Intermarket Price Relationships
An absolutely critical element of Dow Theory is the notion a that forecasted transition to a new primary price trend in the overall market is not validated unless the price action in the common stocks of two separate economic sectors “confirm” a change in the overall trend in US economic activity.
Specifically, Dow Theory posits that there is a fundamental relationship between industrial businesses that produce goods and transportation businesses that transport these goods. Indeed, Dow Theory posits that the fundamentals of the businesses in these sectors are inextricably linked from a fundamental perspective. Due to this strong fundamental intermarket link, Dow Theory posits that a nascent price trend in one of the sectors must be “confirmed” by the price action in the other sector. Just as the economic activity in one of these two sectors is unsustainable without the economic activity in the other, it is posited that a major trend in the price action of the stocks of one sector will not be sustained if the there is not a similar major trend in the price action of the stocks in the other fundamentally connected sector.
Dow Theory posits that if a price rise in industrials stocks is not matched by a similar rise in transportations stocks the move in industrials may be a “false” one. This is because the producers of goods and services rely on transportation services to bring supplies and to transport goods to market. If production by industrials companies is about to rise, demand for transportation services is necessarily set to rise. If the prices of transportation stocks are not rising it may indicate that transportation volumes are not expected to rise – and this necessarily brings into question whether the price rise in industrials is truly due to an increase in final demand for industrial goods. Likewise, if the prices of transportation stocks rise but the prices of industrial stocks to not, one should question whether the rise in transportation stocks is sustainable. Increases in the share prices of transportation companies can only be sustained if there is an increase in the demand by industrial companies for supplies and/or an increase in the demand of final consumers for the goods produced by industrial companies.
Here we see that a “technical rule” in Dow Theory that is based on price action – the so-called “confirmation rule” - is really method for trying to discern a major change in the flow of macroeconomic fundamentals. In this case, the specific prices that are being observed are used as proxies for (actual or expected) economic activity in two different sectors of the economy. The existence of an inextricable fundamental inter-market relationship between businesses in these two separate sectors of the economy provides a plausible foundation for using market action in these to sectors to identify changes in the trend of an otherwise “hidden” or “unobserved” third variable, which is economic activity or expected economic activity. Economic activity is something that cannot be observed directly in real-time without a major lag. However, the price action of the stocks in both of these sectors can be observed in real time. If there is a clear shift in the price action in the stocks of both sectors, it could be an indication that there is real-time information about a shift in the economic activity in these sectors that is being reflected more or less instantaneously in the prices of stocks in these sectors.
Thus, we can see that Dow Theory is not concerned exclusively or even primarily with using old lines on a chart to predict new lines on a chart. At its core, Dow Theory is concerned with identifying price patterns on a chart that are likely to be connected to certain corresponding macroeconomic phenomena. If the price action is indeed connected to macroeconomic phenomena in the posited way, then subsequent price action can be accurately predicted. By contrast, if the price action turns out to be unrelated to underlying fundamentals, then this old price action cannot be reliably be used to predict future price action.
How can we trust if a particular change in the observed price action is, in fact, related to an underlying change in macroeconomic activity? One of the unique aspects of Dow Theory is that it employs the principle of “confirmation” in the price action of two fundamentally related sectors – industrial and transportation. Furthermore, Dow Theory posits an interesting fundamental relationship between changes in the economic activity of these two sectors and changes in the economic activity of much of the rest of the economy.
Applying this basic insight of Dow Theory to present circumstances one might ask: Is the price action in bank stocks currently telling us anything about the future volume and/or the cost of credit in the US economy? And if so, would a major change in the volume and/or cost of credit provided by banks – signaled by price action in bank stocks -- have a major impact on other economic sectors?
Here is another interesting question: Between the following two alternatives, what would likely have a bigger impact on the overall US economy?
- A 5% decline in the volume of manufacturing production and in the volume of physical goods transported.
- A 5% decline in the volume of credit provided to all consumers and businesses.
Viewed in this manner, it should be clear that there is no reason to limit application of the insights of Dow Theory with respect to key intermarket relationships to the observed relationships between the Industrials sector and the Transportation sector. Any major intermarket relationship that can provide a signal for changes in overall macro-economic activity could be useful for predicting overall trend in stock market prices that serve as a “barometer” of overall economic activity.
The Dow Jones Industrial Average was initially intended by Charles Dow himself to serve as a “barometer” of overall economic activity in the US. However, Dow Theory does not only posit that the Dow Jones Industrial Average serves as a barometer of overall economic activity. Most importantly, it posits that the price action in the common stocks of certain economic sectors of the economy may be able to “anticipate” the economic activity and the price action of the stocks in the other sectors of the economy. This method of forecasting is posited to be effective not due to a mere statistical correlation of prices, but due to intermarket relationships that are fundamental in nature. Dow Theory is not premised on mere correlation of price action (as is applied in much conventional “quant” analysis of intermarket price action); it is premised on underlying causation between the price action of economically linked sectors.
In this spirit, we ask: Is there likely to be a causal link between the price action of US bank stocks and the economic activity of banks? Will there be a causal link between and the economic activity of banks and the economic activity of other sectors of the US economy? If both of these questions are answered affirmatively, it logically follows that there is good reason to believe that the price action in bank stocks may very well anticipate the price action in other sectors of the US economy.
Final Thoughts
Dow Theory posited a unique way to causally relate changes in price action to changes in fundamentals. Unfortunately, for reasons that cannot be elaborated on in this article, the overall project to integrate technical and fundamental analysis was largely abandoned over the decades by market practitioners. Instead, technical and fundamental analysis became more highly specialized and developed in almost complete isolation to each other. The separation has reached the point where practitioners in these fields only tend to address the other discipline when they are trying to discredit it. And in academia, both disciplines have been disregarded in favor of a dogmatic advocacy in favor of the Efficient Market Hypothesis.
Unfortunately, by the 1940s, Dow Theory, had stopped evolving meaningfully. The theory became ossified and did not keep up with the times. Even worse, the few remaining practitioners of Dow Theory detached it almost completely from its fundamental roots. In doing so, these practitioners removed much (if not most) of the value provided by Dow Theory which was based on the integration of technical and fundamental analysis. The remaining “husk” of Dow Theory, as promoted by most of the few remaining practitioners today, is a simplistic system of technical analysis that has become severely outdated.
At Successful Portfolio Strategy we pay very careful attention to inter-market fundamental relationships and their links to the price action in key sectors of the financial markets. In particular, we have conducted extensive research that has uncovered extremely important relationships between price cycles, fundamental cycles and various intermarket relationships (intermarket prices and fundamentals) that uncover the otherwise hidden links between these price and fundamental cycles. In this sense, we have taken some of the initial insights of Dow Theory to another level entirely and added many more. Our research on cyclical fundamental and price relationships is at the core of our approach to portfolio strategy and the management of our portfolios. Our research-based portfolio management systems have enabled us to vastly outperform our benchmarks, particularly on a risk-adjusted basis. We hope this article will spark you to think about how you can leverage the integration of technical and fundamental analysis for the benefit of your own portfolio.
In particular, we think it will be beneficial, at this particular time, for investors and traders to think carefully about what the price action in bank stocks might mean for the overall equity market. The answer to this question might very well hold the key for determining whether the stock market rally since October 2022 has merely been a bear market rally or whether the US equity market is in the initial stages of a new bull market.
For further details see:
Dow Theory Is Posing A Big Question That You Need To Answer