Dow Theory

on . Posted in Dow Theory

Will the Stock Market Crash Again?

Over a hundred years ago newspaper editor Charles Dow worked out that stock markets move in six distinct phases. It’s still relevant today let me explain why.

In a quarter century of my involvement on the stock market, I've been fortunate enough to witness two full blown booms and a couple of Crashes. The first was the run up to the collapse of 1987; the second ten years later a third in 2008, can we foretell the fourth?

If you believe Charles Dow's theory that investment markets run in cycles, we should be able to expect the next crash or major market correction. Dow worked out that there are six distinct stages in each market cycle. Understanding where we are in that wave should assist greatly in maximising your return.

Let's begin with the upward phase, known as the Primary Bull Market.

Stage One - Accumulation

The cycle begins while pessimism still reigns, few members of the public own shares, there's gloomy economic data, lack of investment in fixed assets caused interest rates to start falling and corporate profit growth is pedestrian. During this time, shares have extremely low valuations; almost nobody seems to want them. But those with patience start to take long term bets. The "smart money" starts accumulating shares and despite the gloom, prices start rising slowly. The initial improvement off the basement is invariably followed by another sell-off with shares quickly giving up half the gains.” Bears” (Sellers) come out to play, leading the disdainful chorus against those hardy souls claiming the Bull Market has started. But to the surprise of most, after a quiet period the market starts to firm upwards again. Provided its lows stay comfortably above the basement, the bell has rung. The” Bear” is indeed back in hibernation.

Stage Two - Big Move

This is where the easy money is made from shares. It is usually the longest period of the Primary Bull Market and the time when prices rise the most and across the broad market. “The rising tide lifts all ships”. This period co-insides with an improving business cycle, company profits begin to rise again and valuations of shares improve. During this stage, the professionals are fully invested in shares and benefit as prices rise across the board. The investing public slowly starts to wake up to the trend with a few early adopters joining in.

Stage Three - Excess

As surely as night follows day, excess comes after the broad improvement. This is the most dangerous stage of every stock market cycle. Confidence surges to extraordinary levels, interest rates keep falling, valuations of shares rise excessively and the public climbs into stocks as though they've discovered a secret path to quick money. From the shoe shiner in Joe Kennedy's day ahead of the 1929 Crash to the New York cabbie circa 2000, when "amateurs" start tipping shares you can be certain the top of the market isn't far off. At this stage the party is in full swing, speculation excessive and only the sober observer is able to see that the mother of all hangovers is just around the corner. Prices discount perfection. Hello, SA residential property market 2005?

Every upward trend is followed by a slide, termed the Primary Bear Market. Dow discovered that it, too, has three distinct phases.

Stage One - Distribution
Just as the steady accumulation of stocks by long-term investors marks the early stage of a Primary Bull Market, so the distribution of shares signals the stirring of the Bear. Professionals start to realise that although business conditions remain favourable, they are not that good anymore and certainly do not justify the excessive ratings. Almost imperceptibly, interest rates start edging higher again, not sufficient to break up the public's share market party which is in full swing, but loud enough to wake the Bear from hibernation. Although "smart money" begins to move out of stocks, there's little in the mass media to suggest the good times will end anytime soon. Indeed, not only is the investing public very much involved in shares, they're still willing buyers, mopping up shares sold in progressively higher volumes by the professionals. Even as prices ease off their peaks, the first drop is usually followed by a short, sharp recovery of around half the losses, emboldening the Bulls who loudly proclaim the long-term trend is intact. But soon another fall occurs, and provided that takes shares below the previous low, its conformation that the Bear Market has truly begun.

Stage Two - Big Move

This is the most painful time in any stock market cycle for long-term owners of shares. At this point the downward trend becomes entrenched, the fall in share prices being reflected in the economy where business conditions continue to deteriorate, earnings forecasts are missed or reduced across a broad range. Profit margins shrink, revenues fall and corporate profits keep dropping. All the while interest rates keep rising and bankruptcies increase. As the picture gets gloomier, the selling of shares gathers further momentum.

Stage Three - Despair

At the top of the Bull Market, you'll hear the clarion call of a "new age", hope springs eternal and the champagne never stops flowing. It's precisely the opposite in the trough. All hope is lost, the economy will never recover, satin gives way to sackcloth, and shares aren't touched with the proverbial barge pole. During this time, valuations reach rock bottom but even so, the selling continues as the public, which piled in during the Excess stage, wants out at any price. News from the corporate sector is bad, and the economic picture is bleak. The last buyer has packed his mule and headed for the hills. The market keeps falling, usually going lower than even the pessimists believe possible. There is almost always a massive blow-out at the very bottom (just like the huge volume at the very top) with share prices reflecting an apocalyptic situation. Only then are we in the basement.

Although the Dow Theory is aimed at the stock market generally, it holds true for most investment markets and, if you look carefully, even individual shares.

Where are we now? My reading would be the JSE is in a Primary Bull market and at the mid- to latter part of Stage One possibly about to enter Stage Two? Valuations are still reasonable; interest rates can still fall although they are likely to remain at current levels before they rise, Confidence is uncertain to flat but likely to begin improving. The smart money is buying selectively. Will we have another Excess stage? Almost certainly. But that should be years away having recently completed Stage Three of a Primary Bear Market in 2008. Until then, it remains safe to hold and even accumulate shares.

 

Should you wish to have a bespoke share portfolio structured and managed on your behalf I would be glad to discuss the options with you. If you would like advice on your current portfolio of shares or just general stock market advice please call me and my team and I will be glad to assist you.