Tuesday, May 13, 2014 - Record Highs and Dow Theory

Record Highs and Dow Theory

by Sinclair Noe

DOW + 19 = 16,715
SPX + 0.8 = 1897
NAS – 13 = 4130
10 YR YLD - .03 = 2.62%
OIL + 1.38 = 101.97
GOLD – 1.00 = 1295.70
SILV + .03 = 19.63

Record highs are seldom pretty; they tend to be sloppy affairs, much like our celebrations. You would like a nice neat procession, but people are marching in different directions, candles blow out, hot wax is spilled.

It doesn’t seem like we should be having record highs in the first place, but there it is:  the S&P 500 hits 1900 for the first time ever; the Dow Industrials at record highs; the Dow Transportation Average confirms with record highs. This is important because it goes back to one of the more important technical indicators in the US stock market, the Dow Theory.

The Dow Theory is based on the writings of Charles Dow, the founder and editor of the Wall Street Journal, and dates back more than 100 years. There are actually several tenets of the theory that examine the major trends in the market and posit that the market is efficient, that it incorporates and discounts all news with greater accuracy than any individual. Once a trend is in place it is likely to continue until there is definitive evidence of a reversal; in this light, the slog through the first quarter might be considered as nothing more than market noise. Dow Theory also holds that volume confirms price trends.

And the theory also holds that the Dow Transports should confirm the Dow Industrials. The idea was that the Industrial average reflected the factories scattered around the country and the transportation average consisted of the companies that hauled the goods from the manufacturer to the market. If manufacturers are producing more, they have to ship goods to consumers, so if you want to know about the health of manufacturers, look to the performance of the companies that ship the goods. The two averages should be moving in the same direction; that is, they should confirm. So, if the Transportation average hits record highs, which it did, the Industrials should also hit new highs, which happened yesterday.

In mid-March, the transports broke above prior 2014 highs while the Industrials still lagged below their corresponding 2014 high. This could have been interpreted as a divergence, and even a signal to sell the industrials. However, Dow Theory tells us that industrials lag transports. It makes sense, because goods need to be transported before they can be sold.

Now, if you want to try and front-run Dow Theory, you want to pay attention to sales. Today, the Commerce Department released April sales figures, and they were flat, up just 0.1%, but this follows a revised 1.5% increase in March; that was the largest increase since March 2010 and reflected pent-up demand after a brutally cold winter. So, March sales were spectacular, and that was reflected in the Dow Transportation Average, and eventually the Dow Industrial Average confirmed the Transports. And now, the April numbers look weak despite data like employment, as well as manufacturing and services industries surveys, suggesting the economy regained strength early in the second quarter.

A second report from the Commerce Department showed that retail inventories excluding automobile stocks barely rose in March. The government had assumed a big increase in these stocks when it made its advance growth estimates last month for gross domestic product at 0.1% growth. March trade, construction spending and factory inventory data, which the government did not have in hand for the GDP estimate, suggest downward revisions to output; likely showing the economy contracting slightly. Core sales were down 0.1% in April; core sales strip out automobiles, gasoline, building materials and food services, and correspond most closely with the consumer spending component of the GDP.

Meanwhile, the Fed reported today that Americans racked up more debt in the first quarter, the third straight quarterly increase, thanks in large part to heftier mortgages. The report on household debt and credit showed however that mortgage originations dropped to their lowest level since the third quarter of last year. Outstanding household debt rose by $129 billion from the previous quarter, boosted by a $116 billion jump in mortgage debt and smaller rises in student and auto loans.

And in the sometimes twisted logic of Wall Street, this might be considered good news, the economy isn’t collapsing but it certainly isn’t growing enough to warrant a change in interest rate policy from the Fed. Any increase in interest rates could hobble consumers, businesses, and even the government.

Prices and wages been have sluggish since the 2007-2009 recession, and especially so in the past couple of years. Inflation remains low, and it undershot the Fed’s 2% target for the 23^rd consecutive month in March, based upon the personal consumption expenditures price index. Stubbornly elevated unemployment puts downward pressure on inflation. We still have slack in the labor market, so we’ll likely have very low interest rate targets for quite some time.

Meanwhile, we’re wrapping up earnings reporting season and according to Bloomberg research, almost 76% of the 453 companies in the S&P 500 that have reported earnings had results that were higher than analysts' estimates and approximately 53% of them exceeded revenue estimates. I know this is a rigged game between corporations and analysts, but companies are making money and sitting on piles of cash.

The corporate cash pile reached $2.02 trillion in the latest quarterly filings of 2,300 non-financial companies in the Russell 3000 Index. According to Bloomberg, the total rose about 13% from a year earlier in each of the two latest quarters, the fastest six-month gain since mid-2011.  If investors aren't applying some sort of haircut to the valuations of companies with hefty amounts of cash overseas, perhaps they should be; that is the mantra of activist shareholders. And so companies are beginning to pick up M&A activity as well as share buybacks and dividend increases. Capital spending on structures, equipment and intellectual property by all US companies in 2013 increased 3.9%, the slowest pace in three years. Eventually there will be value in reinvesting in the company to grow revenue; we’re not there yet, but we’re getting closer.

Again, one of the tenets of Dow Theory is that a trend in place is likely to continue until there is definitive evidence of a reversal; we’re not there yet. The trend is bullish; the supporting data is only mildly positive. In this instance, you stay in the market and remain alert to possible reversals. The level of support for the Dow, now moves up to the 16,550 range. On the upper end, there really is no level of resistance when you hit new highs, with the possible exception of Fibonacci expansion levels, which could put a ceiling around 16,800.

Meanwhile, if you’re looking for a negative divergence, you need look no further than the Russell 2000 Index of small and mid-cap stocks. The Russell has been persistently below its 50 day moving average since early April, and last week it dipped below the 200 day moving average; yesterday it bounced up above the 200 day and remained above the average today, despite losing 12 points. So, if you are looking for an early warning, this is a good place to look. If the Russell can move above the 200 day average here, it would have to be considered positive and also confirmation of the blue chips. If there is a breakdown from here, it might drag the blue chips lower.

Now, even if the market moves lower from here, it doesn’t mean we’re crashing back down to the 2009 levels; there is no definitive evidence for that kind of a move; there is plenty of fear mongering; there are plenty of perma-bears and they are about as accurate as a broken clock. The world is not coming to an end, at least not today; the market is not crashing, at least not today. In fact, we’ve been going through one of the best five year bull runs in market history. The VIX, the volatility index is at its lowest levels in more than a year. The major trend is bullish but this is no time for complacency. One of the tricks to profitable trading is knowing when to let winners run, and when to lock in profits.

These are the days of milk and cookies. Enjoy it while you can.