Tower Private Advisors

 Capital Markets Recap

The first editor of the Wall Street Journal was Charles H. Dow (1851-1902). From editorials he wrote, what has been termed Dow Theory was distilled. According to the bible of technical analysis, Technical Analysis of Stock Trends, by Edwards and Magee, Dow, “did not think of his ‘theory’ as a device for forecasting the stock market, or even as a guide to investors, but rather as a barometer of general business trends.” Among other of its basic tenets is this one, the two averages, the Dow Jones Industrial Average and the Dow Jones Transportation Average, must confirm each other for a trend to be valid. For example, a 52-week high in the Industrials is unconfirmed (as an indicator of some trend) until the Transportation index also notches a 52-week high. As one might expect by the terminology, a trend is suspect until it ha been confirmed.

The thinking behind the notion of confirmation of the two averages was simple and elegant. If the Industrials was an indication of the strength of an economy, then there ought to be more goods being shipped; thus, the Transporation average should reflect that strength. Today, one could rightly argue that much our economy isn’t shipped, it’s downloaded, which is to say that, in a service economy, transportation isn’t a relevant indicator. Still, the concept continues to work, and, accordingly, ignoring the chart below may be done at one’s peril.

And here’s a closer look, with details added. The lower green circle marks a new high for the Industrials, but the next peak for the Transports wasn’t a new high, leaving the advance by the Industrials unconfirmed.

Maybe this is a perfect use of the Theory as envisioned by Charles Dow, as a general barometer of business conditions. It seems that most folks don’t think that the latest iteration of QE (Quantitative Easing) will have any effect on the economy (I disagree.) On that count, the Dow Theory seems supportive. In a sense, it’s saying, sure, the Industrials are up, but that move isn’t supported by strength in the economy. If it were, the Transports would be up, too.

Market participants should care, too, however, given the Theory’s tendency to be right. In that context, the Theory is saying the upward trend for stocks is not to be believed until it’s the Industrials average is confirmed by the Transports average, and it needs to advance by about 7.5% to do so.

The latest issue of The Economist featured a concise guide to Quantitative Easing, featuring a guide to investing under three possible scenarios. I agree with what’s expressed in it, so I call it a balanced look  at the phenomenon. Here is a link to the article, but it may require a subscription. The gist of the article is this:

• Previous rounds of QE have had the effect of boosting stock prices “without boosting profits.” It’s what some guy from HSBC has likened to a “sugar high.”
• On the other hand, QE may be underestimated, as “it is impossible to know what things would have looked like without the previous rounds of monetary stimulus.”
• As for the effect on stocks–the pieces of electronic paper traded amongst market participants–”investors will be pushed out of low-risk assets into the stockmarket,” and that will push stock prices higher.
• “The other asset class to benefit from previous rounds of QE has been commodities. This seems rational.” They would benefit from increased economic growth and any inflation.
• There are three possible scenarios:
  1. The economy stays stagnant, inflation low.
     • “The right strategy in those circumstances would be to buy government bonds.”
  2. The economy recovers to pre-crisis growth levels.
     • “The right strategy then would be to buy equities.”
  3. Inflation accelerates rapidly
     • “In that case, buy commodities, especially gold.”

Maybe they don’t use the middle finger in Iran…

Short one this week…

Graig P. Stettner, CFA, CMT

Chief Investment Officer

Tower Private Advisors