Technical Analysis

The following chart indicates how long it took the Dow Jones Industrial Average to reach different levels in increments of 1000 points:

DJIA Date Reached Time Elapsed 1000 Nov/72 76 years 2000 Jan/87 14 years 3000 Apr/91 4 years 4000 Feb/95 4 years 5000 Nov/95 9 months 6000 Oct/96 11 months 7000 Feb/97 4 months 8000 Jul/97 5 months 9000 Apr/98 9 months 10000 Mar/99 12 months 11000 May/99 1 month
It is intriguing that it took 98 years for the Dow to reach 4000 points, from 1896 to 1995. It took only another 5 years for the Dow to almost triple from 4000 to 11,722 points.
Let’s hypothesize that the Dow at 4000 to 6000 is reasonable, and that the increase in the Dow, since Dow 6000, has been speculative.
Let’s further assume that current reasonable Dow levels are back to the 4000 to 6000 point range. Look at Dow 4000 and Dow 6000 below and compare them to today’s market levels as well as historical Dow Jones averages.
DJIA – PRICE EARNINGS AND YIELDS (as of 8/28/02)
TODAY HISTORICAL
AVERAGE AT DOW 4000 AT DOW 6000 PE Ratios 20.5x 14.2x 9.4x 14.2x Dividend Yields 1.8% 4.4% 4.0% 2.7%

Facts

The NASDAQ is down about 80% from its high.

The Japanese stock market is down 65% from its high. (If the Dow lost 65% of its value from the high of 11,722 points, the Dow would be 4,100 points.)

At the July 23rd market close, the S & P 500 had lost 50% of its value, and the Dow was down 34% from its high. (If the Dow lost 50% of its value from it’s high of 11,722 points, the Dow would be 5,861 points.)

The average loss of the top 25 equity mutual funds is 21% in this calendar year alone.

Keys to Analyzing Direction of the Market

New York Stock Exchange margin account borrowing two years ago was at $278 billion dollars, and it is now half of that. Margin account borrowing is a solid measure of professional investors activity, and that activity is down. Indications are that margin account borrowing will continue to decrease.

The Rally from the lows in July for the last several weeks has indicated two things:

There is very little upside volume in this rally;

Professional investors are selling into the rally, and switching to bonds, rather than accumulating common stock.Statistical Analysis

George Schaefer, the great Dow Theorist, wrote about and perfected the theory of the 50% principle and the 200-day moving average. Both are important indicators of where the market is headed.

The way to understand the 50% principle is to understand examples. The three examples listed here are identified as follows:
The 50% level identified from the beginning of this bull market 20 years ago to the high of 11,722 points on January 7th, 2000.

The 50% level identified as the high of 11,722 points 2 years ago to the low in the current bear market of 7,702 points on July 23rd of this year.

This years 50% level based upon the highs and the lows of the Dow in this calendar year.
(1) The Dow high of 11,722 points on January 7, 2000 started from a Dow bear market low of 766 points 20 years ago. The increase in Dow points from 766 points to 11,722 points, divided by 2, equals 5,478 points. Adding those points to the starting low of 766 equals the 50% level of 6,244 points, which can also be calculated by subtracting the 5,478 points from the high of 11,722. The 50% principle assumes that as long as the Dow is above 6,244 points, technically the Dow remains in a bull market position.
This gets more complex because we know this is not a bull market, and the primary trend of the market is down. About $7 trillion dollars of losses from the high have been sustained so far. And while technically the market remains in a bull posture, the market is poised to breach Dow 6,244 sometime in the next few years, at which point the Dow will seek a level where great values can be found. The above is the most extreme example of the 50% principle, which we need to keep in mind as we continue to analyze the existing condition of the market.
(2) The Dow low of 7,702 on July 23rd , 2002 subtracted from the high 2 years ago of 11,722 creates a 50% level of 9,712 (11,722 - 7,702 = 4,020 divided by 2 = 2,010 + 7,702 = 9,712). Technically, as long as the market remains below 9,712, this leg of the market remains bearish and the trend remains down.
(3) This year’s Dow high in March of 10,635 subtracted from the July 23rd low of 7,702 creates a 50% level of 9,168 in this calendar year. As long as the Dow remains below that level, the Dow remains in a downward, or bear posture, for 2002.

So we have three levels defined by the 50% principle that are important from a technical point of view: 9,712 and 9,168, which the market is below; and 6,244, which the market remains above. As long as the Dow remains below those two 50% levels, the Dow remains in a bearish position, and the primary trend of the market is down. If the 6,244 level were breached, then technical analysis would confirm this is a full-blown bear market. At this point Wall Street firms typically confirm a bear market. If that happens it would be expected that the markets would be in a state of utter chaos. At that point investors dump stock at any price, panic ensues, gold goes up in price, and U.S. Treasury bonds become the investor’s best friend.

The next tool to examine is the 200-day moving average of the Dow which professional investors call the “investment line”. This is a good measure of the direction of the market. Currently the 200-day moving average of the Dow is about 9,700, 2,000 points below the high of 11,722. The trend of the 200-day moving average is down, and it has not turned up for 2 years. The position of the 200 day moving average, coupled with the fact that the Dow remains stubbornly below two important 50% levels, means that the Dow is positioned to breach its longer term 50% level of 6, 244 points. Unless the 200-day moving average turns up, and it can only turn up if the Dow remains above 9,700 for an average of more than 200 days, investors may expect the market to continue to deteriorate.

Conclusion

Facts do not bode well for the market returning to an upward trend. Debt overhangs the market. Bankruptcies, lower corporate earnings, state and federal government deficits because of lower tax revenues, and lack of cash flow all contribute to negative economic conditions that make it mathematically improbable the market can return to higher levels over the next few years. Indeed, it is more likely the long-term 50% level of 6,244 will be breached within the next 12-24 months and that the market will return to historically sound levels of value.
It is noteworthy that only a few years ago the Dow was at 4000 points and everybody was ecstatic with the values their stocks had obtained. At Dow 6000 the stock market would reach a level more in line with average historical Dow Jones values. But in full-blown bear markets, historical averages are breached. Great values become available. It is likely we may see these values around a 4000 Dow.

Now is not the time for prudent investors to test whether or not these theories are in error by being invested in common stocks. Now is the time for prudent investors to enjoy a cash position and to liquidate into this rally any common stocks left in a portfolio.

There are still very few values in this market in common stocks. The primary trend of the market is down. The probability of a further rally from these levels is less likely than the intermediate term possibility of the Dow breaching the July 23rd lows of 7,702 points. Further deterioration from this years low of 7,702 points would cause the Dow to test its long-term 50% bull market level of 6,244 points.

Caveat Emptor!
George Rauch
September 5, 2002

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