Part of the essence of Dow Theory has to do with confirmations, which at their root level look for congruencies in the marketplace. With many indicators frequently moving in different directions, alignments across key market barometers can substantiate the existence of an underlying trend.
Price action over the past few weeks has led to an abundance of confirmations, in addition to Dow Theory recently turning bullish. Let’s examine a few of these moves to understand what lies ahead.
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First, let’s direct our attention to the S&P 500 and the Russell 2000 indexes. As discussed in previous remarks, the composition of our economy has changed drastically from Charles Dow’s time. Instead of Industrial companies dominating the landscape, our modern economy now generates significantly more output from the service and technology sectors.
This has led some to adopt a broader view of “confirmation of the averages” to include the S&P 500 and the Russell 2000 small-cap indexes. The idea is that if our country’s largest and most well-capitalized companies (with significant international exposure) AND domestically oriented smaller US growth companies are both moving higher, then the rally is broad based and is likely to continue.
The chart below shows the S&P 500 breaking out to new highs once again, and sustaining the move.
This next chart shows price action in the Russell 2000, which is also exceptionally bullish. After floundering for years and underperforming most other indexes, small-caps have regained their strength and are currently the market leaders in terms of momentum.
The zoomed-in chart on the right shows the remarkable 15 day winning streak that has propelled the index to new highs. That streak looks to be stalling but is still remarkable.
Together with the S&P, it appears that wide swaths of the market are all moving higher in unison. This suggests significant underlying strength and bodes well for future gains.
As a quick aside, the Russell 2000 has been rallying for a variety of reasons, mostly tied to Trump’s economic plan. If regulations are relaxed, taxes are lowered and money is dumped into infrastructure projects, the small caps stand to benefit more than their larger brethren. These small cap firms are better positioned to benefit from stimulus spending, and often pay a higher effective tax rate than multinational companies. The strong weighting towards financial and bank stocks has also helped the Russell 2000 rally as financials have been a pocket of strength.
Moving on, we can also find bullish confirmation in the action of the NYSE Advance-Decline line. Recent commentary has pointed out that the A-D line has not confirmed the bullish sentiment, but my perspective is a little different.
Analysts frequently look at the version of the Advance-Decline line that includes all issues in the NYSE. The problem with this is that many of those issues are bond related. Since stocks and bonds often move in opposite directions, this has a tendency to dilute the movements of stocks in the index.
This next chart below shows the NYSE Advance-Decline line computed ONLY from common stock issues. This is more representative of the market breadth for the NYSE.
As you can see, when we focus on common stocks only, the NYSE Advance-Decline line does confirm the broader movement of the market.
Next, a quick look at Richard’s PTI. After dropping well below its moving average, the PTI has recovered and currently sits in bullish territory.
With Dow Theory, the S&P 500, the Russell 2000, the NYSE Advance-Decline line and the PTI all confirming the bullish action, it begs the question, is it time to buy more stocks?
The answer to this question is a nuanced yes and no.
The whole idea of confirmations revolves around the idea of identifying the primary trend of the market. While confirmations are great at doing this, then often represent less than ideal entry and exit points. This is because confirmations often occur when the market is overextended one way or the other. (Notice the current overbought readings in the top two charts.)
We all know the mantra with investing is to buy low, sell high. But if you’re always waiting for new-high confirmations to add to positions, then by definition you’re working against this concept.
Here’s how I like to approach this. Bullish confirmations, such as the ones we’re seeing now, indicate the direction of the primary trend. When we see them, we know that we should be in accumulation mode rather than distribution mode. But the timing of those accumulations is very important.
Instead of using bullish confirmations as the buying trigger, we should view them as opening the doors for future purchases. As for the timing of those purchases, it’s often better to wait for a pullback before committing new money.
The difficulty of this approach lies in buying stocks as they are headed down. At the first sign of market weakness, many of us, including myself, begin wondering whether this is the beginning of a new downward primary trend. We have a hard time embracing one of the most important aspects of Dow Theory, which is that the prior confirmation remains in effect until either reconfirmed, or an opposing confirmation takes place.
In a primary bull market, we need to recognize that pullbacks are often secondary moves within the broader primary trend. As such, these are the times when we should be adding to our holdings.
Just as many of us waited for holiday discounts before committing money towards presents, we should wait for a market discount before committing new money towards our investments. Over the long run, this idea of buying on weakness, rather than on strength, will help to bolster your returns.
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