We made a big point about the failure of the Dow Industrial Index to confirm the new high made by the Dow Transportation Index in May. We had good reason for concern, as you can see from the chart (arrows at the left). The transports made a higher high on July 7, but the industrials failed to do so. Within a few weeks of the failure, the market gave up more than 15% and did not recover until October.
After the lows they made together on October 4, the indexes broke above the series of highs they had previously made in August and September, and they continued to move higher together. New recovery highs were reached in late October, in December and again on February 22 (arrows).
The Dow Industrial Index continued higher and has now recovered more than it lost. It even took out the May high that it had failed to match in July. However, the Dow Transportation Index started to diverge from the industrials (dotted lines), and according to Dow Theory, unless it makes a new high, we should expect the market to head south.
We have also noticed that rail traffic has declined, and the sale of diesel fuel has plunged in the last several months. This gives us reason to question the market's rally. Our concern deepened as the price of oil kept rising, because that puts considerable pressure on transportation stocks, and on the Airlines, in particular.
All of a sudden last week, after the one-day drop on March 6, the transportation stocks added 6.0%, while the industrials rallied just 3.7%. This brought the transportation average to within just 0.3% of a new high, and when that high at 5351.32 is reached, it will confirm the recent high made by the industrials.
The index gained 170 points on Thursday due mostly to gains in the Rails and the Airlines (Union Pacific was responsible for 29 points). On Friday, the Airlines gave most of it back, but the rails did not.
The industrials are higher than they have been at any time since 2007 while the transportation stocks are lagging. The transports are still below their July 7 high of 5618.25. However, according to Dow Theory, there will be a buy signal of some significance when the transports simply confirm the February high at 5368.93. And it will make it likely that they will go on to 5618.25.
The first goal is only 18 points above Friday's close and it is important, but even more important than reaching this new high would be a failure to do so. A failure will make it likely that the index will test its March 6 low of 5047.25, and possibly trigger a general market retracement.
— Fred Goodman, a registered investment adviser and Certified Financial Planner, publishes MarketMonograph, a daily Web-based subscription service specializing in technical stock market analysis and the application of economic indicators to market timing. You can reach him at fred@marketmonograph.com.
Love the book recs Fred. I am basically a trend follower so I'll have to check them out."Market Wizards" is one of my favorite trading books of all time.
Interestingly Seykota said the "Donchian Crossover" system worked well with futures, commodities, and indices but worked poorly with individual stocks, for whatever reason.
These are the best recommendations, @Scott and @Fred! We are the beneficiaries of your both sharing your accrued knowledge--and war stories. Thanks! I'm going to check everything out.
Google "Donchian" to get the arithmetic behind the Donchian bands, a very nice device for trend following systems.
A very fine book on the subject, and one that tells stories about Ed Seykota is Kedrick Brown's 2006 book, "Trend Trading." I found it to be well written and learned a lot from it. It is also available at Amazon.
I have a number of books to recommend and have listed them here with brief reviews. Two on this subject and very well presented are "Way of the Turtle," and "Trading in the Zone."
More on Ed Seykota from the seminal book "Market Wizards."
"Ed Seykota turned $5,000 into $15,000,000 over a 12 year time period in his model account - an actual client account. Ed is self-taught, but influenced early on in his career by Richard Donchian. He is a commodities and futures trader and a Trend Follower."
As somebody who traded for my own account for years, I understand and totally agree. As I stated the market will beat you up if you let it get to your emotions. It is very hard. You almost have to figure out how to turn off your brain and let the computer take control -- and admit that's your fate.
There is nothing more anxious and nerve-wracking than staring at a red screen and watching your investments plummet as they did in 2008/2009.
I will have to check out that book, what a hilarious title!
Another guru of mine is Ed Seykota who follows simple trend-following systems and allegedly made clients 5,000% returns or more over decades. He lives on an estate on the shores of Lake Tahoe and now runs a trading organization called TradingTribe.com. He claims to largely follow his computer system and only spends about "a few minutes" every morning entering or exiting trades.
Seykota has always said that trading is more about your mind than it is about the market. People bring their own fears, conflicts, and baggage to the market and that's how it can get the best of you. I believe this is a universal phenomenon.
I have had some experience with averaging Scott, and as a matter of fact, in my market newsletter in the 70's I presented a mock portfolio based on Robert Lichello's clever system disclosed in his poorly named book, "How To Make $1,000,000 in the Stock Market Automatically!"
The book is still available for under $5 at Amazon and makes use of a system of varying the investment according to the stock movements, it is very effective if stuck to. But there's the rub. It takes nerves of steel to buy during a "flash crash," and I for one don't have nerves of steel.
Using any system on autopilot is not my cup of tea. However, if it is modified according to the needs of the investor as he/she approaches retirement I'm all for it.
Obviously, also, to your point if you are close to retirement or in retirement that changes the picture entirely and you probably want a much lower exposure to stocks.
Actually, I can understand that the market post-2000 can give people ulcers but I believe the major indices have made the markets look much worse than they actually are.
The indices are the problem. If you dollar-cost averaged over 2000-2010 and put the money into reasonably price, growing companies you would have been fine!
What do I mean by that? Well, let's say you seek out a stock selection formula such as the one I advocate (low-PEG stocks such as those we picked for the IU25 index which is now beating the market). But sticking to low-P/E or low PEG, you are reducing your risk.
Now, our IU25 does not have a long enough track record (one year). But there is one completely transparent system like this with a similiar methodology, which I was in fact influenced by. It's Joel Greenblatt's "Magic Formula." Here are the results:
Magic Formula performance vs. S&P 500 Index, 1999-2011*(Click to enlarge)
As you can see, if you were in the Magic Formula stocks over the long-haul 2000-2010, you would have done fine. 17% annualized in fact! 2008 would have been a sweat, but if you'd added a few stocks instead of panicking then you would have done even better.
So why do I think this is better than going by Indices? The Magic Formual focuses on growth and fair valuation. The large indices COMPLETELY IGNORE VALUATION.
In fact, the S&P 500 is engineered to add companies at exactly the wrong time -- they are favored when their market caps get really big (regardless of valuation), regardless of P/E, and they end up being added to the index during "bubbly times." This is why in 1999, the S&P 500 became overweight technology at exacly the wrong time, and why in 2007 it became overweight financials at exactly the wrong time!
Why is this so? Well, for whatever reason, the S&P likes to add companies just after their market caps have grown extraordinarily large. And it does the same things with sectors -- when they become huge and outsized, they make the indice overweight that sector. This is like if you were in the market for a house but you waited to buy because "you want to see prices go up more before you buy."
So the answer is to manage your own risk and avoid market-cap indices that arbitrarily add stocks without regard to the "fairness" of their valuation.
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Voters feel more favorable about an incumbent president when the economy is good. So expect the Obama administration to do everything possible to push up the market.
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