Theory and Practice (DIA,IYT)

Theory and Practice (DIA,IYT)

 

It was all spelled out some eighty years ago, by a little known, London-based equity analyst who wrote,

The fellow lived and traded through a great many financial ups and downs, including two global military conflagrations and several cataclysmic economic down-cycles that sundered both the U.K. and global economies.  But the above quotation was made with respect to the RISE in stocks in the late 1920’s!

 

That’s right.  It was when the bull market was still hot, and the push to all-time highs on the Dow was feeding the ‘roaring’ descriptor of the 1920’s that our analyst Cornelius penned these words.

 

And now we’ve come full circle.

 

Because again, today, it’s the push toward all-time highs on the indexes that presents the greatest challenge for investors.

 

And just as Cornelius’ charming reset of Thomas Paine’s famous line spoke to the troubles the professional investment class was experiencing in 1928, so, too, must we admit that traditional systems of stock measurement are today failing to signal with the certainty they once did.

 

And that means we must all reconsider our approach to owning stocks.

 

Particularly, we must abandon any thought of purchasing equities for the long haul.

 

Why?  Because the coming swings in prices are going to come faster and be sharper than anyone can predict.  And the eventual reversal to a full-on bear market will also come like a lightning strike out of the blue.

 

It has started…

 

The run-up from the elections in November is just such an example.  No one expected anything.  And likewise no one has any clue in which direction we’ll head next.  But we do know categorically that the next move will be just as steep and will catch the majority of investors by complete surprise.

 

That’s precisely why shortening our time horizons and nimbly closing losing trades is imperative.

 

A willingness to trade on both the long and short sides will also provide a great advantage to investors.

Our approach to trading this market was developed in the aftermath of the crash of 2008/09, when it became clear that the authorities would not permit traditional, open-market price discovery mechanisms to operate.  We saw immediately that the intervention – unprecedented in its scope and aggressiveness – would lead to a market melt-up that was equally unprecedented.

 

And for exactly that reason our method for trading the intermediate trend – anywhere between six weeks and six months – was developed.

 

Mea Culpa

 

But we were wrong in our belief that the melt-up was then at hand.  After eight years of steady bull market action, that blowoff top that we expected to occur way back then, did not transpire according to the schedule we set for it.

 

It was delayed.

 

Until now.

 

We’re now confident that the latest market action and the general macroeconomic and earnings environment are setting the stage for a liftoff unlike anything we’ve ever witnessed.  And though we may get a quick five to ten percent decline (or more) before the next leg up commences, we’re rather certain that there will be a next leg up, and that it will push the indexes to new, unimaginable highs.

 

But now we trade.

 

DOW as I say!

 

One of the indicators our friend Cornelius no doubt studied was Dow Theory, invented by Charles Dow of Wall Street Journal fame in the last decade of the nineteenth century.

 

Dow blended studies of the Transport and Industrial averages to concoct a theory that has been very useful for the last century and that we monitor without fail on a bi-weekly basis here at Normandy.

 

And we turn now to that same theory with a twofold purpose, 1) to see what it has to offer as a forecasting tool (knowing full well it may have outlived its usefulness in that regard), and 2) to configure a creative trade for you for the week.

 

And with that, on to the Dow Transports!

A look at the trannies shows that the March slide has brought them below their former lows at 9000.

 

For a Dow confirmation to occur, we would have to see the Industrials trade below their last retracement low at roughly 19,700 (see below).

 

Now, whether that occurs is anyone’s guess.  But if it doesn’t, and the trannies continue on their merry way northward, it’s more than likely the ‘correction’ is now over.

 

Have a look at the Industrials –

As you can see, the Industrials would have to decline another 1000 points from today’s action to confirm the trannies latest losses, and that represents a significant pullback.  It would be a welcome occurrence for many bulls, to be sure, as it translates to a roughly 7.5% retracement, peak to trough.  Not a bad hook on which to hang a ‘new buying opportunity’.

 

As it stands, however, it’s impossible to tell if that will actually happen.  Dow Theory is only useful once the confirmation (or non-confirmation) has entered the realm of history.  At that point it becomes tradable.

 

What do we do with it, then?

 

What’s observable over the long term, is that Dow Theory confirmations eventually do occur.  That means the current gap in performance between the two will be ironed out at some stage in the future.  We should warn that it can take many months in between confirmations, and often longer, running to a year or two – or more – before the two begin trending in unified fashion.  But for the most part, the wait is not so lengthy.

 

So with that in mind, we offer you the following more sharply comparative paste-up of the two, and a trade for the week.

 

Have a look –

This is the SPDR Dow Jones Industrials ETF (NYSE:DIA) charted alongside the iShares Transportation Average ETF (NYSE:IYT) for the last month, a period during which their respective performances were widely divergent.

 

Our trade today is a bet that the two will return to synch over the next three months.  And we’re playing it as follows.

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Many happy returns,

 

Matt McAbby

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