Several things worth remembering are contained in the following excerpt from a Wall street Journal editorial written by William Hamilton 1921…On Dows theory…..”secondary rallies in a bear market are sudden and rapid, conspicuously so in the recovery after an actual panic break. The test is not at the bottom but in what the market does after a rally…” ” there is always heavy buying in support , to protect weak accounts to large to be liquidated”…… Robert Rhea – The Dow theory.
Charles Dow believed that the stock market as a whole was a reliable measure of overall business conditions within the economy and that by analysing the overall market, one could accurately gauge those conditions and identify the direction of major market trends and the likely direction of individual stocks.
From my observation of historical movements this statement has held true for 100 years.
When you apply this methodology to the Australian economy, you can see the market index has not made new highs past the 2007 bull market high of 6852 points. Applying this type of methodology to a post GFC economy of minimal wage growth and low economic manufacturing expansion, constantly changing political leadership and a trading partner in China with slowing GDP growth, there is very little growth trajectory of forward price into equities. This observation does not discount the individual daily movements but rather the broad movement of prices.
When this methodology is applied to individual stocks, it goes a long to explain why price trends come to an end as the market can see no reason to take prices higher. Often announcements will make a stock spike higher, and only after the market has confirmed the news will prices follow on. Or in the case of the market discounting the news, prices fall back as potential buyers cannot see a future benefit from the news and short term traders sell to take quick profits.
Exploration mining companies that make announcements around recent discoveries or survey results often see a spike in the underlying stock price, however as the market will then “do the sums” of the results or discovery, the overall picture of future profits can change dramatically as the cost of setting up mining operations and production can mean many years of future debt before a payoff occurs.
Measure this against a company that has production output in place and the price of the underlying commodity increases in value then the immediate payoff is a benefit to the profitability of the business.
This type of analysis is what Dow’s theory is based on, the markets assessment of the immediate future benefit.
Now apply this to the Australian financial sector with current high level investigations of business models and practices, the immediate future looks cloudy. The financial sector index XFJ broke into ta downtrend in May 2017 as the banking sector came under a cloud of investigation.
The Australian economy has not followed the US economic recovery and remains sluggish, the index not making post GFC high’s tells us this.
Take Dow’s theory one step further and you will find markets are very good at predicting future economies. The best example of this is Donald Trumps election in November 2016. The market immediately saw economic benefits of a republication president and bid the market into a 9 year bull market.
So what now that the US economy has caught up to prices?
If you listen to the news about how well the economy is doing and the jobless rate is at 10 year lows, then why is the Index correcting lower?
The S&P 500 last week was 11.5% down from the highs, the Australian index has made a similar retracement in a “growing” economy.
There can be 2 reasons for the correction of price,
1. The market does not believe the economy can expand further to justify current equity valuations. Economic forces of inflation and interest rate rises will bring pressure onto company profits.
2. Valuations have moved ahead of the market expectation of value in the short term.
With these 2 observations we can see the S&P 500 has entered into a down trend, this has occurred as the economic indicators of jobs growth and underlying company profits point to a strong economy.
The S&P weekly chart shows the February March April consolidation of price before the price trended into the 16th of September high. The current retracement has moved directly past the previous low, so the movement is described as “corrective”
The problem with “corrective” moves is they do not change underlying trends. Only a price rally into a lower high and a move lower into a new low can be deemed as a trend change.
This picture of forward earnings shows an accelerating trend between 2017 and 2018. Clearly the market is concerned about something, by way of the current selloff in the face of strong earnings.
The real insight into this chart is the continued earnings growth into mid 2008 before the major bear market down turn, some 6 months after the 2007 equities high. The same can be inferred to the “tech wreck” of 2000 as earnings growth continued into 2001. The graphic above only highlights the delayed nature of reporting against immediate market sentiment and only reinforces the Dow theory concept.
US China trade wars and US midterm elections could be used as the reasoning behind the selloff, this would then dictate that a change in these two current events would change the market belief about the future, importantly if the current earnings picture can be maintained into 2019 and beyond.
Traders should be very concerned with the future movement of the S&P breaking the recent 2604 point low, as this would place the US into a primary down trend and we would look back at the current short sharp secondary rallies referred to in Dow’s theory as being the precursor to the new bear market we didn’t want to see.
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