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 stocks (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:
- In order for industrial companies to increase their earnings, they had
to produce and sell more goods.
- If industrial companies are selling more goods, then transportation companies
must be delivering more goods to retailers and wholesalers.
- Therefore, in a healthy economy, both industrial companies and transportation
companies should be experiencing revenue growth.
- If industrial and transportation companies are growing their revenues,
then the industrial and transportation stocks should be attractive to investors.
- 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 (DJIA) once again
was unable to post a new closing high, leaving an economic divergence in place
relative to the high made in the Dow Jones Transportation Average (DJTA) 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).
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 IBM (IBM), 3M (MMM), Boeing (BA), Chevron (CVX),
and Johnson & Johnson (JNJ). However, the Dow (DIA) also contains Visa
(V), Goldman Sachs (GS), and American Express (AXP), since the present day
economy relies heavily on the financial sector. The Dow Jones Transportation
Average (IYT) still has railroads, such as Union Pacific (UNP) and Norfolk
Southern (NSC), but it also contains more modern logistics companies, such
as United Parcel Service (UPS), Fed-Ex (FDX), and J.B. Hunt (JBHT).
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, 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 (TLT) also aligns with the recent hesitant behavior by the Dow Jones
Industrial Average.
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 S&P 500
(SPY) and an equally-weighted S&P 500 ETF (RSP). 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:
- How To Monitor The Risk Of A Midterm-Election-Year
Stock Correction
- 5 Reasons Your Simple Bear
Market Plans Could Backfire
- The 2 Most
Important Questions For Investors
