Chuck Carlson - Stock Market and Investment Opportunities

Published on 29 Apr 2013

The power of process will be essential for unemotional investing in this age of turbulence. Investors will learn about profit opportunities in 2013 and the power of dividends.

Dow Theory for Timing Purchases and Sales - As their acceptance increases, their reliability tends to diminish

In this respect the famous Dow theory for timing purchases and sales has had an unusual history.* Briefly, this technique takes its signal to buy from a special kind of “breakthrough” of the stock averages on the up side, and its selling signal from a similar breakthrough on the down side. 

• The calculated—not necessarily actual—results of using this method showed an almost unbroken series of profits in operations from 1897 to the early 1960s. 
• On the basis of this presentation the practical value of the Dow theory would have appeared firmly established; the doubt, if any, would apply to the dependability of this published “record” as a picture of what a Dow theorist would actually have done in the market.

A closer study of the figures indicates that the quality of the results shown by the Dow theory changed radically after 1938—a few years after the theory had begun to be taken seriously on Wall Street.

• Its spectacular achievement had been in giving a sell signal, at 306, about a month before the 1929 crash and in keeping its followers out of the long bear market until things had pretty well righted themselves, at 84, in 1933. 
• But from 1938 on the Dow theory operated mainly by taking its practitioners out at a pretty good price but then putting them back in again at a higher price.  
• For nearly 30 years thereafter, one would have done appreciably better by just buying and holding the DJIA.

In our view, based on much study of this problem, the change in the Dow-theory results is not accidental. It demonstrates an inherent characteristic of forecasting and trading formulas in the fields of business and finance. 

• Those formulas that gain adherents and importance do so because they have worked well over a period, or sometimes merely because they have been plausibly adapted to the statistical record of the past. 

But as their acceptance increases, their reliability tends to diminish. This happens for two reasons:

• First, the passage of time brings new conditions which the old formula no longer fits. 
• Second, in stock-market affairs the popularity of a trading theory has itself an influence on the market’s behavior which detracts in the long run from its profit-making possibilities. 
• (The popularity of something like the Dow theory may seem to create its own vindication, since it would make the market advance or decline by the very action of its followers when a buying or selling signal is given. A “stampede” of this kind is, of course, much more of a danger than an advantage to the public trader.)

Dow Theory - Market Phases

Dow Theory - Market Phases

Primary movements have three phases. Look out for these general conditions in the market:

Bull Markets

Bull markets commence with reviving confidence as business conditions improve.
Prices rise as the market responds to improved earnings
Rampant speculation dominates the market and price advances are based on hopes and expectations rather than actual results.

Bear Markets

Bear markets start with abandonment of the hopes and expectations that sustained inflated prices.
Prices decline in response to disappointing earnings.
Distress selling follows as speculators attempt to close out their positions and securities are sold without regard to their true value.

Dividend Yield

Dow believed that stocks yielding below 3.5 percent were over-priced "except there be some special reason." Richard Russell analyzed the dividend yield on the Dow from 1929 to 1959 and found that the market tended to reverse when yields had fallen to between 3 and 4 percent.

Since the 1960s the dividend yield on the Dow and S&P 500 has declined to around 2 percent. We should be careful not to leap to the conclusion that the market is way over-valued. Examine the S&P 500 chart below and you will observe that the Dividend Payout Ratio declined over the same period, from 60 to 30 percent.



Companies are retaining a higher percentage of earnings, preferring to return capital to stockholders by way of share buy-backs rather than by way of dividends. This favors investors who prefer the enhanced earnings growth offered by share buy-backs, without the tax implications associated with dividends.

We should therefore switch our focus to earnings yield, rather than dividend yield, in order to avoid any distortion. An earnings yield of below 5.0 percent would offer a similar over-bought signal to a dividend yield of less than 3.5 percent (0.035/0.7=0.05). This translates to a price-earnings (PE) ratio above 20. I use a PE ratio above 20 to signal that a bull market is entering stage 3.

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Volume Confirmation

Increased volume on declines and dull activity on rallies provide additional evidence of an overbought market. Conversely, lack of activity on declines and increased volume during rallies indicate an oversold market. See Volume Patterns for further detail.

http://www.incrediblecharts.com/technical/dow_theory_market_phases.php

The famous Dow theory for timing purchases and sales

1. The famous Dow theory for timing purchases and sales has had an unusual history.
2. Briefly, this technique takes its signal to buy from a special kind of "breakthrough" of the stock averages on the upside, and its selling signal from a similar breakthrough on the downside.
3. The calculated - not necessarily actual - results of using this method showed an almost unbroken series of profits in operations from 1897 to the early 1960s.
4. On the basis of this presentation the practical value of the Dow theory would have appeared firmly established; the doubt, if any, would apply to the dependability of this published "record" as a picture of what a Dow theorist would actually have done in the market.
5. A closer study of the figures indicates that the quality of the result shown by the Dow theory changed radically after 1938 - a few years after the theory had begun to be taken seriously on Wall Street.
6. Its spectacular achievement had been in giving a sell signal, at 306, about a month before the 1929 crash and in keeping its followers out of the long bear market until things had pretty well righted themselves, at 84, in 1933.
7. But from 1938 on the Dow theory operated mainly by taking its practitioners out at a pretty good price but then putting them back in again at a higher price. For nearly 30 years thereafter, one would have done appreciably better by just buying and holding the DJIA.
8. In our view, based on much study of this problem, the change in the Dow-theory results is not accidental. It demonstrates an inherent characteristic of forecasting and trading formulas in the fields of business and finance.
9. Those formulas that gain adherents and importance do so because they have worked well over a period, or sometimes merely because they have been plausibly adapted to the statistical record of the past.
10. But as their acceptance increase, their reliability tends to diminsh.
11. This happens for two reasons: First, the passage of time brings new conditions which the old formula no longer fits.
12. Second, in stock-market affairs the popularity of a trading theory has itself an influence on the market's behaviour which detracts in the long run from its profit-making possibilities.
13. (The popularity of something like the Dow theory may seem to create its own vindication, since it would make the market advance or decline by the very action of its followers when a buying or selling signal is given. A "stampede" of this kind is, of course, much more of a danger than an advantage to the public trader.)

Ref: Intelligent Investor by Benjamin Graham