Dow theory divergence in low volume trade points to trouble


LABOUR DAY has come and gone, which means the US summer season is officially over. Wall Street brokers have made their way back from the Hamptons and returned to their desks to prepare for the final stretch of 2012.

The year has been kind to the owners of common stocks so far, with the Dow Jones Industrial Average delivering solid, double-digit percentage-point gains during the first eight months and the SP 500 returning to the levels that prevailed just before stock prices went into free fall in the autumn of 2008.

It is often said that bull markets climb a wall of worry, and the old, 19th-century adage has certainly proved true in the year to date. Indeed, investors’ asset allocations appear to have been swayed more by the potential for further unconventional central bank action, rather than the myriad of threats – from the persistent turbulence in the euro zone to a rapid slowdown in Chinese economic activity – that would have been expected to keep risk appetites in check.

Long-term investors are undoubtedly cheerful but they would be wrong to take comfort from the stock market’s relatively tranquil price action in recent months, as the latest upward move has been accompanied by a marked deterioration in technical indicators and a growing air of complacency in the professional investment community.

The major market averages’ risk-reward profile is decidedly asymmetric at this juncture, with the potential downside far outweighing any possible upside. A nasty surprise could well lie in wait for the increasing herd of bulls, who display uncritical satisfaction with their current allocation to risk assets.

The “Dow theory” is a useful place to start, given its long and rich history as a staple for wannabe technical analysts, and it reveals some discomfiting divergences that question the true health of the stock market’s present condition. Far from confirming the optimism of the bulls, the study of recent price action and trading volume suggests the upturn in the major stock market averages has become increasingly fragile.

When some of the financial world’s savviest short-term traders hint that they are positioning for an impending downside shock, it would perhaps be wise to take notice.

For those unfamiliar with Dow theory, it was derived from a series of Wall Street Journal articles penned by the newspaper’s founding editor, Charles Henry Dow, between 1900 and his untimely death, aged just 51 years, in 1902. The journalist assembled the industrial average in 1896 and the railroad average a year later, which meant he had only a limited sample of historical data from which to develop a cohesive theory.

Dow’s failing health meant he had little time to put all his thoughts on paper, but William Peter Hamilton, his successor at the financial newspaper, used his predecessor’s theory as the basis for the market predictions he made in more than 250 articles between 1903 and his death in 1929.

Hamilton clarified the basic outlines of the theory in the 1922 classic, The Stock Market Barometer, and the study of stock price movements was further refined by Robert Rhea, who reduced the analysis to a set of theorems an ordinary investor could understand, in the timeless 1932 book The Dow Theory.

Dow believed both stock averages must confirm a trend, and Rhea noted: “The movement of both the railroad and industrial averages should be considered together . . . Conclusions based upon the movement of one average, unconfirmed by the other, are almost certain to prove misleading.”

In this regard, it is interesting to note that the recent cyclical high in the industrial averages has not been confirmed by the transport averages. Indeed, the transportation average reached a cyclical peak during the summer of 2011 and registered a lower high earlier this year.

Rhea warned: “A wise man lets the market alone when the averages disagree.”

Dow argued that trading volume should confirm price trends, and Rhea believed investing in a market that had become “dull on rallies and active on declines” was foolhardy.

The entire advance off the crisis-induced lows during the spring of 2009 stands out in this regard, as trading volume has been consistently higher on weakness. Indeed, the coefficient of correlation between the 90-day average of trading volume and stock prices has been a disturbing -0.84 since the cyclical bull market began, compared with a positive correlation of 0.88 during the early years of the great 1980s bull market.

Not only has trading activity collapsed, with volume at the recent cyclical high in stock prices almost 60 per cent below the figure recorded at the 2009 bottom, but daily price changes have also faded into insignificance.

Since the crisis-induced low, stock prices have registered a percentage point move of more than 2 per cent once every nine trading sessions, and a more than 3 per cent change once every 28 sessions. Recently, however, the daily fluctuations have been minuscule: there has not been a single 2 per cent change in almost 50 trading sessions, and the market has not registered a daily move of more than 3 per cent in nine months.

Dick Arms, a respected figure in the world of technical analysis, observes: “There are times when the market gives the impression it is fading into nothingness. Volume becomes very low, trading ranges become very small, volatility becomes very low. Also, there is very little change in market levels, and day-to-day fluctuations are minimal.

“Looking back at history, when that happens, it is almost always a sign of a market high point.”

Investors have been warned.

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