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Lasco Report: Dow Theory 101 - Required Reading
Posted on January 19, 2006

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January Newsletter
Dow Theory 101 - Required Reading
Enrico Orlandini
Lasco Report
17 Jan, 2006

I'm sure I've mentioned the words "Dow Theory" dozens of times over the last seven years, probably even hundreds of times, but it dawned on me that I've never given a detailed explanation with respect to the theory itself. I've talked about value, non-confirmations, and such things countless times, but I've never given you the basics. I'm sure most of you are a lot more familiar with Fibonacci, Gann Theory, Charts, and countless other technical tools and investment philosophies than you are with the brainchild of Charles Dow. That's a shame because it has, in my opinion, stood the test of time better than any other technical tool that I can conjure up with my limited metal capacity. In fact, I'll go a step further: it is more applicable today than it was one hundred years ago. Why? Precisely because it does deal with value and value, or the absence of it, that makes this market so different from any other. Also it has another quality that I just love, i.e., simplicity. It is eminently understandable by any person with a modicum of IQ.

First, I want to talk a bit about the man! Charles Dow began his career as a reporter specializing in business and finance. He was the founder of the Dow-Jones financial news service in New York and in 1889 he began a little newspaper called The Wall Street Journal. In particular, he wrote the editorials for the Journal and gained quite a following in the process. I've read a lot of these epistles, and although Charles Dow was attributed with the founding of the body of knowledge now known as Dow Theory, I can't find a single instance where he ever referred to it as his theory. What's more, his articles are the only written record with respect to his thoughts on the market. Unfortunately, he never bothered to write a book.

The crux of Dow's philosophy has to do with two concepts: value and market "swings". Value comes before the 'swings' in terms of importance. The swings, or shifts in direction, were often related to the value (or lack of it) present in the market place. The swings could be classified into one of three categories: primary, secondary, and tertiary and all going on at the same time. The primary trend was the main trend of the market and usually lasted years. The secondary trend was the counter trend movements that always occur in a Bull or Bear market and they could last months. Finally, the tertiary movements were the day-to-day movements that could occur for little or no reason. Value is another issue and it often outran the swings. Simply put, share prices would often go lower than one expected during a Bear Market and higher than one could imagine during a Bull Market. Dow often saw value in a market when the PER fell below 8 and likewise saw a lack of value when the PER exceeded 17. [Today's PER for the S & P 500 stands at 20.58.] Another measure of value had to do with the dividend paid by the market. Six percent or greater offered good value while three percent or less left something to be desired.

Charles Dow recognized that "the stock market is a barometer of the country's and even the world's, business," and he set out to develop a theory that could effectively and consistently read that barometer. What's more, the market is forward looking so his barometer would be of considerable help in reading the state of the economy six months or a year down the road. To use Dow's own words " the stock market is not trading on what is common knowledge today but upon the sum of expert knowledge applied to conditions as they can be foreseen many months ahead." That's pretty heady stuff if you ask me.

Dow's star burned bright but as is often the case, it didn't burn for very long. He died at the relatively young age of fifty-two in the year 1902 and it was left to others to elaborate on his original thoughts. Two men in particular, William Peter Hamilton and Robert Rhea, made significant contributions to Dow's original work. Hamilton introduced the concept of confirmation and non-confirmation. He believed that rallies/declines would continue their present course as long as the DJIA and the Transportation Index moved in tandem. In other words, every time the DJIA would make a new high/low, it would be necessary for the Transport Index to confirm by also registering a new high/low or vice-versa. If either failed to confirm the others new high/low, it meant that the tide and turned and the primary/secondary movement had come run its course.

Robert Rhea followed in Hamilton's footsteps and continued to refine both of his predecessors' works. Unfortunately, he suffered the same fate as Dow, dying well before his time. E. George Schaefer was next in line and believed firmly in Dow's concept of value. He differed somewhat with Schaefer and Rhea in that he put more emphasis on value than he did on the pattern of the averages. Schaefer then added some finishing touches when he added the 200-day moving average, the short interest ration, Dow's 50% Principal, and more. I especially find the 50% Principal useful when it comes to analyzing commodities. Here's a real life example: the price of oil peaks at 71.87 and then makes a significant correction down to 56.59. There it stabilizes, builds a base, and begins to rally. Once it closes above 64.23, 50% of the correction, one can be reasonably assured that we will test the previous high.

To conclude this discussion, I want to take a paragraph from Richard Russell's web page: "Schaefer believed that mass emotions were changing the character of the stock market. He realized that Wall Street was gathering a much larger following year after year, and that the American public was becoming much more involved with investments. This relatively new phenomenon of mass emotions, Schaefer believed, had to be taken into consideration as far as classic Dow Theory was concerned." Imagine what Schaefer would think if he were alive today! I'm sure he'd find a way to factor in the CNN mass hypnosis that seems to guide the average investor's market-related decisions.

MARKET COMMENTARY

DJIA - The MARCH DJIA gave a significant buy signal this last week when it finally confirmed the recent highs registered in the S & P and in the Transportation Index as well. We had been on the edge for weeks and the DJIA finally gave up the ghost and confirmed what most (but not yours truly) took for granted. I will have to admit that I was surprised, but that is only half the story. Yes, we have a confirmation for the secondary Bear Market rally, but we have a major non-confirmation as far as the primary trend is concerned. What do I mean by that? Let's go back to our Dow Theory lesson and you'll recall that we have primary, secondary, and tertiary trends. Currently, the primary trend is a generational Bear Market decline, i.e., down. Within that primary trend, the Transport Index made an all-time high just some days back while the DJIA is still some 800 points away from its all-time high. That is a non-confirmation according to Dow Theory.

Within the primary trend you may recall that we have secondary movements and, in this case, it would be in the form of Bear Market rallies. We recently saw a confirmation within the context of this secondary trend when the DJIA finally confirmed the recent highs in the Transports. In short, we have a confirmation within a non-confirmation. Which do we follow? Well, if you're a "trader", and you're fast on the draw, you go long looking for a rally to 11,335 if not a bit more. Charles Dow on the other hand would look at this market and decide that there is a complete lack of value. A DJIA with a PER of 20 and an average dividend yielding just 1.9% is a sign of a Bull Market high and not a Bear Market low. [The Transports are grossly overvalued with a PER in access of 100 and a dividend around .7%.] Therefore he would keep his powder dry and wait for better days.

If you observe the two weekly charts below, you will see exactly what I mean. The Transports have been making a series of higher highs for months on end while the DJIA only recently was able to work its way above the previous March highs. What's not shown is the fact that the DJIA is still some eight hundred points below its Bull Market top of January 2000. There you have it, a Primary Bear Market non-confirmation wrapped around e secondary movement's confirmation. A mystery wrapped in an enigma! Where does the importance lie? Always with the primary trend! How do we know that this isn't a new Bull Market? That takes us back to the principal concept of Dow Theory, i.e., value. At no time did the market ever correct to a point where you could find decent values, PER's at +/- 8 and dividends of 6%. We never even came close. How is it that we've managed to sustain such a long and unprecedented Bear Market rally? One word: liquidity! The markets, almost all markets in every major economy, are flooded with liquidity.[1]

This unprecedented action by the world's largest Central Banks has created distortions. It's a shame that Mr. Dow never met Mr. Greenspan; I could just imagine the editorials it would have produced. He would have said something like the following: what we fail to realize, and what every one is just as happy not to talk about, is the fact that this "free money" will come with a terrible price. That price will be the destruction of the U.S. economy as we know it today. Only he would have said it better. As value investors, what can we do about the present situation? The same thing as Charles Dow would do given the same set of circumstances: stay out of the market until value makes an appearance. The Central Banks of the world will win the battle, but the war is already lost. The market will have its way and the primary trend will not be changed with a flood of fiat paper.

CRB Index - This is fast becoming one of my favorite subjects. It is my opinion that we are about to witness significant rallies in certain commodities including, cotton, lumber, corn, and soybeans while other commodities continue to rally even though analysts are calling tops almost on a daily basis. These include almost all metals, sugar, coffee, and oil. Observe the following weekly chart of the CRB Index:






Notice how nicely the Index bounces off the 50-week moving average, using it as support. Also notice how the Index corrects whenever we get more than 12% above that same 50-week moving average. If that holds true, look for a correction once we hit the 350.00 area.

I bought the Index, for the first time in a long time, when we got close to support at 317.00 some weeks back. I believe that the CRB is about to begin a run similar to what we've been experiencing in gold and silver. It will be relentless and will take the Index to highs that most analysts never even imagined. It will stay overbought for weeks on end just like gold has been doing and, like in gold, the day traders will not make any money.

Bonds - This is a difficult market for me to grasp at the moment. The United States in swimming in debt as the Administration runs amuck spending money. Rumors abound that Asian and Russian central banks are diversifying out of dollars, i.e., refusing finance our extravagances any longer. If that is really the case, bond prices should fall in order to drive interest rates up thereby compensating buyers of U.S. paper for the perception of increased risk. That would seem logical to me, but as you can clearly see in the following chart, the bond market has been rallying and that is driving interest rates down:





Notice the series of higher highs and higher lows? RSI, MACD, and the histograms have all turned up. For once the bonds seem to be in agreement with the Federal Reserve. In all honesty, I don't understand this and when I can't understand something, I tend to stay away from it until I see the error of my ways.

US$ Index - here's the most important game in town in my opinion; kind of like the Super Bowl of all the markets. Think of the dollar as the common stock of a company called "America". Over a period of several years, the share price of "America" fell from a high of +/- 122 to a low of +/- 80.00 and did so with little or no interruption. Everybody and their brother were short the dollar and everybody and their brother were calling for the dollar's collapse. As is usually the case, everybody and their brother were wrong, at least for the time being. After several attempts to break down through support at 80.00, the U.S. Dollar Index did the unimaginable and rallied all the way back up to 92.00. The 92.25 level was and continues to be good resistance. We stayed at or near it for weeks and only managed one marginal close above that level. Finally, the dollar seemed to give up and now appears to have turned back down. You can see all of this in the weekly chart of the US Dollar Index below:





Has the secondary rally in this primary Bear Market for the dollar finally exhausted itself? I suspect so and that's why I took a small short position in the Dollar Index. In order to have a good comfort level, I am looking for several things to happen:


I want to see a close below 88.05,

I then want to see a close below the 50-week moving average, and finally

I want to see a close below 86.61 which represents a 50% retracement of the Bear Market rally.


With each occurrence, I will add on a bit to my short position. On the other hand, a move and close back above 90.27 would indicate to me that we could see yet another retest of resistance at 92.25. I will just sit tight and let the market tell me what to do although the burden of proof is on the Bulls.

Oil - Here's another commodity that I really like and it seems to be on the edge of a significant leg up. As you can see below, oil has the same appearance as the CRB (and gold for that matter). A multi-year Bull Market that continually uses the 50 - week moving average as support. I wish I could say that I had owned oil for as long as I owned gold, but that's not the case. I am a recent convert to the oil camp as I waited for a reasonable correction before I jumped on board. I had to wait until oil ran all the way up to 71.57 before a correction finally happened. At the time I identified two possible targets for likely bottoms, 55.72 and 51.97, with the latter a more likely objective. As it turned out, 55.40 was the actual intraday low. I waited a bit until I felt secure in the belief that it would hold and took a long position.





I'm now waiting to add on but want confirmation. Remember my example of the 50% principal above? Well, the 50% Principal says that we need to recover 50% of the decline before we can feel safe that a retest of the old high is in the cards. That target for oil is exactly 64.23 basis the February futures contract. We have been above that several times on an intraday basis, but we've yet to close above it. I want to see a close above it before I add on. Once that happens, and I believe it will be sooner rather than later, oil should make a fast move up to the old high.

Gold & Silver - The best fort last. I don't know how many people have called a top to the gold and silver market over the last five weeks, but I do know one thing, they've all been wrong. On Friday the February gold contract closed at a new Bull Market high of 557.00 and March silver contract wasn't far behind, closing at 916.50 and just below the old closing high. With respect to gold, I will defer to the 50% Principal for the last time in this article. In 1981, the then Bull Market in gold topped out at 887.50 and we began a long decline that lasted almost two decades. The bottom finally came in 1999 at 252.00. That bottom was tested in early 2001, and held, and then the new Bull Market began in earnest. Today there is no doubt in my mind that we are in a once-in-a-lifetime Bull Market, but using the 50% principal I can't really be "sure" until we close above 569.75, basis the cash price, which represents a 50% retracement from the 1999 bottom back up toward the 1981 high. As I type gold is at 562.50 in Europe so we don't have far to go.

A look at the weekly charts below gives us the same take as we had with the CRB and oil. The word I'm looking for is relentless! Also, it is worth noticing how both gold and silver have been technically overbought for several months.









That is a sign of real strength and is the main reason that I haven't jumped on the "we've got a top" bandwagon. I am more than satisfied to let the market tell me when the top is in. After all, it's a lot smarter than I am. The major question in my mind is: will we correct at 569.75 or will we correct? The honest truth is that I don't have a clue. I do know though that markets can stay over bought in a situation like this much longer than most people can imagine. I can also tell you one more thing: if we do manage to get through 569.75 without an major setbacks, gold will find its way to 645.00 much sooner than even the most ardent bull could have fantasized.

In any event, with or with out a correction, I will sit tight on all of my current positions. I am now more convinced than ever that this is the best and only approach to investing in a Bull Market for precious metals.[2] The same applies to gold stocks. I won't go into depth on the stocks as I just published a report on my holding two weeks ago and there have been no fundamental changes to date. The markets in general, and commodities in particular are going to surprise a lot of people before the year is over.

Finally, I would like to conclude this piece with a story inspired by an e-mail received several days ago from a prospective client. In short, she wanted to know if she should take her profits because she had read somewhere that the Bull Market for gold was about to end. I told here that I thought that would be a mistake and explained that most Bull Markets have three phases and we are in the early stages of the second phase as far as gold is concerned. I even went so far as to explain that the first phase is where the smart money gets on board and no one is the wiser. The second phase is where the Morgan Stanley's of the world begin to take an interest in gold. The third stage and final stage is where the guy who runs the elevator is giving you tips on the hot stock he bought last month saying that its up 40% since he bought it and it will triple by the end of summer. I went on to relate that that actually happened to me. I explained that I was heavily invested in the Latin American markets during the Bull Market that ran from 1988 to 1995. My office was in the stock exchange and I was in the elevator heading down to the parking garage. As usual I was in another world counting my future profits because the market had just closed limit up for the eighth straight day, and that's when the elevator operator interrupted my train of thought in order to give me a hot tip. I honestly can't remember the stock, but I smiled thanking him at the same time, and headed for my car. Before I reached my house, it dawned on me thank I was way to greedy and looking for trouble. The next morning, I arrived early at my office and quietly sold every share I owned on a number of exchanges. That was in early December of 1994. The Bull Market topped out two weeks later when Ecuador invaded Peruvian territory. The markets never recovered. With the exception of BVN, I have yet to buy a Latin American stock. We are no where near that type of euphoria with respect to gold. In fact, I would go so far to say that most investment advisors are unaware of the Bull Market in gold. No, you can put that question on the shelf for another two or three years at the very least.

Notes

1. Just to show that the insanity is generalized, the Peruvian Central Bank printed the Sole equivalent of US $130 million in just one day last week!

2. The Gold Fund I manage is up 185% from inception (3/1/04 thru 12/31/05) and is based on the concept of buy and hold. Corrections are nothing more than buying opportunities. Easy to say and hard to do!

Enrico Orlandini
email: [e-mail]
website: Lasco Report

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