The 100 Year Old Dow Theory is now Bearish - Issue #1
“There is always a disposition in people’s minds to think the existing conditions will be permanent. When the market is down and dull, it is hard to make people believe that this is the prelude to a period of activity and advance. When the prices are up and the country is prosperous, it is always said that while preceding booms have not lasted, there are circumstances connected with this one, which make it unlike its predecessors and give assurance of permanency. The fact pertaining to all conditions is that they will change.”
– Charles Dow, 1900
Dow Theory Turned Bearish
The Ivory Hill RiskSIGNAL remains red, and we are still hovering around our maximum cash levels, which is a very solid 60%. Having a lot of cash could be very good for us when the market rips higher.
Before we discuss Dow Theory, I want to address a question I have been hearing, "Why don't you go to 100% cash?" My answer is this, you don't have to go 100% cash to make a big impact on your portfolio when we get back into the markets. There is a reason why we have a maximum cash level in the first place. This is where experience comes into play and I'll share with you what I have learned, and it was baptism by fire. Going 100% to cash in a volatile market can turn into a sh*t show very fast. I have done it many times.
In a down-trending market, we cut our equity exposure, but remain 40-60% invested and 40-60% in cash. These days the only time we will go to 100% cash is if the banking system is falling apart, which at this point in time it is not. Our banking system is solid. Trying to call a top or bottom with 100% cash is difficult, if not impossible. Yes, transferring to cash feels great and makes you look smart if the market continues to tumble, but that usually only lasts a short time. After 1-2 months, the markets normally base-out, move off the bottom, and rise 10-20% while you're sitting in cash. Having been there myself, you feel horrible and look like a moron.
By staying invested and building a 40-60% cash position, and by not playing the “All-or-None Game”, you can still buy some real discounts when the market rips higher. This can end up making a huge impact on your overall returns. By staying somewhat invested you participate in the recovery rally, which is usually very quick. By playing too much defense and trying to sidestep every drawdown the market throws at you will destroy your long-term performance. One of the biggest mistakes I have made is trying to play too much defense and not looking at the long-term odds.
Now, on to what I wanted to address...
I like to monitored technical indicators as a way to support my fundamental analysis, and for the stock markets, that means keeping a finger on the pulse of Dow Theory. The Dow Theory turned bearish after last Friday’s close.
As a quick refresher, Dow Theory is one of the oldest and time-tested technical trading/investing strategies in the history of markets. Charles Dow first published his technical findings in the early 1900s (he was the first editor of the WSJ) including the following six tenets of Dow Theory:
The market discounts all news
The market has three trends
Trends have three phases
Indices confirm each other
Trends are confirmed by volume
Trends continue until definitive signals indicate otherwise
We don’t need to dig into all of these tenets individually (Investopedia's definition of Dow Theory), but the main idea behind Dow Theory is that markets discount all fundamental information and can offer signals about market trends in themselves. Additionally, it is essential that the Dow Jones Industrial Average and Dow Jones Transportation Average confirm the trend in each other as a divergence suggests a nontypical economic expansion or contraction that’s not sustainable.
In practice, Dow Theory is fairly simple: a set of higher highs and higher lows in the Dow Jones Industrials confirmed by a set of higher highs and higher lows in the Dow Transports suggests a bull market is underway and the path of least resistance for the broader stock market is higher. The opposite also is true with lower lows and lower highs in both indices indicating a bear market with new lows being more likely than not.
Due to the subjective nature of the practice of Dow Theory, it is basically impossible to provide legit return numbers or any sort of back test or track record as every investor interprets signals differently and utilizes different time frame charts. And it is important to understand that Dow Theory is not meant to buy absolute lows or sell absolute highs; it is not a timing strategy but more of a trend-following strategy that more often than not, keeps an investor parallel with the primary trend in the stock market.
To that point, Dow Theory signaled a bear market ahead of the steepest drawdowns (but not at the highs) of both the tech bubble and the 2008 Global Financial Crisis. Since then, Dow Theory has offered two bearish signals. First in summer 2015 and the second in the back half of 2018. Both proceeded considerable sessions of volatility and sizeable portfolio drawbacks before turning back bullish, admittedly missing out on some upside in both of those situations.
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Outperformance is achieved through the avoidance of major market corrections and bear markets.