Dow Theory Points To Cash

Charts Monitor, Rather Than Dismiss Fundamental Data

Critics of technical analysis often mistakenly believe that using charts discounts the importance of fundamental data, such as earnings, employment, and economic growth. Charts allow investors to monitor the aggregate investor interpretation of all the fundamental data. Said another way, charts are efficient tools used to monitor vast amounts of fundamental data, which is important since fundamentals ultimately determine which assets classes will perform best. When the economy is healthy, stocks tend to beat bonds. When economic fear dominates, bonds tend to beat stocks.

In this article, we will cover the latest signal from the markets that aligns with maintaining a higher-than-normal allocation to cash to offset investor indecisiveness related to growth-oriented assets, such as Vanguard's Total Stock Market (ARCA:VTI).

Dow Theory Is Based On Economic Common Sense

Dow Theory is based on a series of Wall Street Journal articles written by Charles Dow. We are not experts on Dow Theory, but the basic tenets are easy to understand. Charles Dow believed that:

1. In order for industrial companies to increase their earnings, they had to produce and sell more goods.
2. If industrial companies are selling more goods, then transportation companies must be delivering more goods to retailers and wholesalers.
3. Therefore, in a healthy economy, both industrial companies and transportation companies should be experiencing revenue growth.
4. If industrial and transportation companies are growing their revenues, then the industrial and transportation stocks should be attractive to investors.
5. If industrial and transportation companies are doing well and are attractive to investors, both the Dow Jones Industrial Average and the Dow Jones Transportation Average should be making new highs in unison, serving to confirm a healthy economy.

A Concerning Non-Confirmation For Stocks

If investors believe industrial and transportation stocks are healthy and thus, attractive investments, that speaks to demand. When demand is strong, stock prices rise. Friday, the Dow Jones Industrial Average (DJT ) on April 1, 2014. The 50-day moving average, shown in blue below, helps us monitor the intermediate-term trend in the Dow Jones Industrial Average. The flat look of the Dow’s 50-day is indicative of economic indecisiveness on the part of investors. The inability of the Dow to post a new closing high is an economic yellow flag according to Dow Theory (see point 5 in the list above).

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The Dow Jones Industrial Average, thus far, has been unable to push to a new closing high as the Dow Jones Transportation Average did on April 1, 2014.

The Fed Still Big Part Of Fundamental Equation

Anyone that has followed the markets closely, especially over the last four years, knows that all things being equal the stock market is not fond of any Fed move that slows the printing presses. Friday’s not too hot, nor too cold employment data most likely keeps the Fed’s tapering schedule intact. From The Wall Street Journal :

Friday’s employment report isn’t likely to shake the Federal Reserve from its strategy of slowly winding down its bond-buying program while keeping short-term interest rates pinned near zero well into 2015. Key data points were largely consistent with the Fed’s view of how the economy is evolving. A healthy payroll employment gain of 192,000 in March, taken together with upward revisions to hiring estimates for the two previous months, suggest the labor market is strong enough to tolerate the Fed’s slow retrenchment of its bond program.

Behind The Averages

After reviewing the companies in the industrial and transportation averages, it is easy to see why they represent logical vehicles to monitor the pulse of the U.S. economy. In 2014, our economy is driven by more than just industrial or manufacturing companies. The present day Dow Jones Industrial Average contains traditional producers, such as International Business Machines (NYSE:IBM), 3M Company (NYSE:MMM), Boeing Company (NYSE:BA), Chevron Corporation (NYSE:CVX) and Johnson & Johnson (NYSE:JNJ). However, the Dow also contains Visa, Goldman Sachs and American Express, since the present day economy relies heavily on the financial sector. The iShares DJ Transport Average Index (ARCA:IYT) still has railroads, such as Union Pacific Corporation (NYSE:UNP) and Norfolk Southern Corporation (NYSE:NSC), but it also contains more modern logistics companies, such as United Parcel Service Inc (NYSE:UPS), FedEx Corporation (NYSE:FDX) and JB Hunt Transport Services Inc. (JBHT.O).

How Can This Help Us Manage Risk?

If Dow Theory offers a way to monitor the aggregate interpretation of the economy, earnings, and central bank policy, then we would expect charts of the DJIA and DJTA to be helpful in terms of managing investment risk. Since a picture is worth a thousand words, when the Dow’s 50-day rolled over in 2011 (see orange arrows below), the index dropped an additional 16%. Notice how the Dow failed to make a new closing high before the big reversal in 2011.

Economic Pessimism And Investor Fear

Similar economic warnings came in 2007 and 2008 (see orange arrows in chart below). Notice during the 39% drop in the Dow in 2008 the 50-day never gave a “things are improving” signal, meaning it was helpful from a cash-redeployment perspective. The Dow was not making new highs; instead it was making a series of lower lows, which reflected a period of economic pessimism and investor fear.

Investment Implications – Time To Pay Closer Attention

Does the Dow’s inability to “confirm” the recent high in transportation stocks mean it will be all gloom and doom for the economy and stock market? No, it simply tells us to keep an open mind about some corrective activity in the stock market. While the non-confirmation does not predict future events, it does tell us the odds of a period of economic weakness are higher than they would be if the Dow was able to post a new closing high. As the godfather of technical analysis noted on Twitter (NYSE:TWTR), if the Dow can post a new closing high next week, it would increase the odds that the indecisive period in the markets is drawing to a close.

Our market model looks at numerous risk-on vs. risk-off ratios to monitor the market’s risk-reward profile. The chart of the S&P 500 relative to bonds also aligns with the recent hesitant behavior by the Dow Jones Industrial Averag e.

The weight of the evidence agrees with the Dow and the stock/bond ratio above; stocks remain prudent, but the ongoing vulnerable state calls for a fairly significant cash buffer to offset higher odds of an equity correction. We entered the week with a significant money market stake and we left the week with an even bigger stake. Our core stock positions continue to be the SPDR S&P 500 (ARCA:SPY) and an equally weighted (S&P 500 ETF). Next week’s highlights include Fed minutes Wednesday and PPI Friday.

Weekend Study

Since the Dow closed Friday with a “be careful with stocks” warning, it may be prudent to brush up on risk-management strategies this weekend:

1. How To Monitor The Risk Of A Midterm-Election-Year Stock Correction
2. 5 Reasons Your Simple Bear Market Plans Could Backfire
3. The 2 Most Important Questions For Investors

Written By: Chris Ciovacco