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NOISE CANCELING HEADPHONES

In black swan, DIA, dow theory, ETF, ETFs, GDX, Gold, OIL, transports, Uncategorized, XIU on June 25, 2009 at 4:03 pm

New Dow Theory Position

New Dow Theory Position

I recently went to an electronics retailer in search of “noise canceling headphones” for my iPod. You know, the kind you see people wearing on the airplane – they “cancel” out any ambient noise (my wife calls them “Sarah canceling headphones”). When you put them on you feel like someone shut the door on a noisy party next door. It makes you focus on the topic at hand. In my case I use the iPod mostly for audiobooks and it makes a big difference.

It made me think: “What if we had noise canceling headphones for the markets?”.  Often times, that’s what Dow Theory feels like to me. It cuts through the clutter of the day to day noise in the financial press and gives you an objective answer as to the primary trend of the market. Beyond a doubt the biggest question I get lately is “Is the Bear market over?”  I’m going to give you the answer in this post. But first a refresher:

1. Dow Theory provides us with a binary answer. That means it’s either 1 or 0. There is no room for interpretation. The “noise” as it were, is cancelled out. A “BEAR” signal is in force until such time as a “BULL” signal has been given. Think of the light switch in your kitchen. Once you turn the lights OFF, you can’t turn them OFF again until you turn them ON. There is a lot of bad information on the web about Dow Theory, including some high priced subscription letters that have made many mistakes in the last two weeks interpreting this exact situation.

2. Charles Dow, writing over 108 years ago, used only daily closing prices. An intra-day high is just more noise that is canceled out. The reason is that Dow felt that a closing price trumped all other intra-day prices because it represented a price that traders and investors were happy to carry home overnight. This showed more of a commitment.  This is important as you will see below.

Now I’m going to give you the answer. As you can guess from the image on this post, we are still in a BEAR market. That’s because the last unique Dow Theory signal was a SELL signal way back in November of 2007. That’s right. The light switch has been OFF since November 2007. We are waiting for a Dow Theory BUY signal if and only if the markets can better their most recent secondary reaction highs. What does that mean? That’s technical mumbo jumbo for “the market has to make higher highs and higher lows”. There’s no doubt that the Dow Industrial stocks have done this. They have bettered the May peak by a good margin. However, Dow required the two indicies to confirm each other. The Transport stocks have stubbornly NOT confirmed the high in the Dow Industrials.   The daily close that we need for a Dow Theory BUY signal is a higher close on the Transportation Average of 3404.11.  Above I stated closing prices were important.  That’s because two weeks ago the Dow Transports were on the verge of giving a signal intra-day, and then reversed and closed lower and therefore failed to “flip the switch” to ON.  Let’s look at a chart to see what I mean:

Dow Theory 24 June 09

Dow Theory 24 June 09

The point I am trying to impress upon you is that the Dow Transportation stocks may “know something” that the Dow Industrials don’t.  The failure of the Transports (lower high in June than in May in lower box above) signals a divergence in the indicies.  William Hamilton, Dow’s understudy, warned of such divergences in the indicies as potential danger spots.

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GOLD STAGES LARGEST RALLY SINCE 1979, OIL RALLYING, FEAR INDICATOR SUGGESTS SHORT-TERM BOUNCE IN STOCKS

In dow theory, Gold, OIL on September 22, 2008 at 1:53 pm

GOLD RALLIES ON FLIGHT TO SAFETY… Investors worried about soaring inflation spurred by the bailouts of AIG, Fannie May and Freddie Mac pushed gold up to $878 an ounce. The Federal Reserve in the US is leading the rescue party. An increase in the money supply causes general price levels to rise. Gold is a hedge against such price increases. Also, the Chinese newspaper The China Daily carried an editorial urging diversification out of US$. The buying stampede in gold, known as a “hard” currency, resulted in the largest one-day increase since 1979.

Chart 1

OIL RALLYING AFTER 50% RETRACEMENT… After a massive move in oil to a record $150 a barrel, the July to September correction took prices back near $91. This coincided with an OPEC statement suggesting $90-$95 Oil was acceptable. Now I’m looking for oil to rally back to the declining blue trendline around $107-108.


Chart 2

VIX HITS HIGHEST LEVEL IN YEARS… The market’s “fear” gauge hit levels previously seen only at short-term bottoms in the stock market. Generally, spikes to extreme levels are followed by short-term rallies. Yesterday’s panic selling in US financial stocks may have been one such time. Once the fear starts to subside (as it is today – highlighted in yellow) it usually results in a market rally.

Chart 3

BLACK SWAN, COMMODITIES FALL, ENERGY STOCKS DROP, DOW THEORY SELL SIGNAL STILL VALID

In dow theory, OIL on July 25, 2008 at 5:45 pm
BLACK SWAN…. Naseem Taleb’s new book is entitled “Black Swans”. It depicts the role of chance in life and in the financial markets. Last week the SEC changed the rules on “naked shorting”. This has been one of Wall Street’s dirty little secrets for years, now illuminated by the SEC’s revelations. This was an arrow aimed squarely at the short-sellers of the bank stocks in the US. These people would sell the shares of the banks without owning them, hoping to buy them back at lower prices and thus reap a profit. The SEC essentially dropped a “match” on a very over-sold “gasoline” type situation. The result was the US Financial sector rose 13% by the close of the market on Thursday — a Black Swan. Rarely seen, this event was a 11 standard deviation event. To put this in perspective, a four standard deviation event is supposed to happen once every 31,000 years. (On a bigger scale this is exactly why I have a problem with Modern Portfolio Theory and CAPM….but that is for another day). Major turns in the market are normally marked by such events. I am not turning bullish completely on US bank stocks, however, my bullish antennae are raised.

COMMODITY PRICES FALL… DB Commodities Tracking Index (DBC) which represents a basket of commodities (including crude oil, heating oil, gold, aluminum, corn, and wheat). Chart 2 shows it having broken its 50-day moving average. Another reader asked if the downturn included agricultural markets. Chart 3 shows the DB Agricultural ETF (DBA) already threatening its 200-day average after failing a retest of its March high. Better weather conditions in the Midwest have caused profit-taking in grain markets [DBA includes corn, wheat, soybeans, and sugar].

Chart 2

Chart 3

ENERGY STOCKS DECLINE… As I wrote in my June 4th and June 17th Market Letters, oil prices and energy stocks were due for a pullback. The momentum indicators flashed SELL a the new high in oil, as they did not follow suit. Support should come in around this level at the 200d Moving Average. Moreover, even if oil prices drop to $100 and gas drops to $8, this level represents good value. One stock of note is Petrobank Energy and Resources. At $93 oil, the company will cash flow $640M next year on it’s Bakken property alone. The stock has become a darling of the mutual fund arena and is severely oversold. A bounce back to $50 is not out of the question.

Chart 4

DOW THEORY SELL SIGNAL IS STILL VALID… According to Dow Theory, the Dow Industrials and Dow Transports can give buy and sell signals if they act in unison. Recall I’ve equated this to watching the tide on two shores of the same body of water. Chart 5 shows how the Transports stubbornly refused to make a new lower low when the Industrials broke down from their May high and made a new low.

Chart 5

The Dow subsequently moved to new lows for the year and the Dow Theory sell signal remains in place. The Dow Transports must move above its June 2008 high and the Dow Industrials must move above its May 2008 high to trigger a Dow Theory buy signal.