August Lows Back In Play

10/5/2015


Fundamentals always trump technicals, and no chart can reveal what's unexpected by investors.

However, charts can help reveal when the supply and demand for shares are out of balance. To see how, think of a stock's price as having three components:

• The underlying fair market value.

• The discount or premium to fair value caused by investors' misunderstanding of the current environment.

• The discount or premium to fair value caused by investors' excessive optimism or pessimism.

Dow Theorists typically assume investors understand the current situation pretty well, in aggregate, with that understanding reflected in the average price of 30 prominent stocks for the Dow Industrials and 20 for the Dow Transports. But Dow Theorists acknowledge that investor sentiment is more volatile than underlying fair value, so they use significant highs and lows in the averages to help distinguish short-term swings in sentiment from more significant changes in the majority money opinion.

Consider, for example, the Aug. 25 closing low of 15,666.44 in the Industrials, reached after a five-day plunge that included some panic selling. From Aug. 25 to Sept. 16, the Industrials rebounded nearly 7% to 16,739.95, retracing more than 40% of the May-to-August decline, as investors put money to work — presumably because they felt stocks were trading at a discount to fair value.

The Transports also reached a key low on Aug. 25, closing at 7,466.97 after an eight-month drop of 19%. From Aug. 25 to Sept. 17, the Transports rallied 10% to 8,215.44, retracing 43% of their December-to-August decline.

If both averages close below their Aug. 25 closing lows, it would suggest underlying fair market values are deteriorating. Why? Because a move to new lows would imply that prior low points — even points reached amid a near-term peak in bearish sentiment — are not low enough to attract investors.

Conclusion

The averages have set up a fairly classic Dow Theory decision point, with clear points to watch.

If the Industrials and Transports close below their respective Aug. 25 lows of 15,666.44 and 7,466.97, the bearish primary trend would be reconfirmed under the Dow Theory. If one or both of the averages can avoid a breakdown below those points, then both averages rebound above the mid-September closing highs of 16,739.95 in the Industrials and 8,215.44 in the Transports, the Dow Theory would shift to the bullish camp.

For now, as a partial hedge, hold a higher-than-normal portion of your equity portfolio in short-term bonds or cash. Our buy lists have 30% to 32% in a short-term bond fund.


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