Dow Theory Says Look out Below

US stocks fell heavily overnight on news that the manufacturing sector contracted in the month of August. The Dow Jones index declined around 1%, the S&P 500 0.7%, while the NASDAQ fell 1.1%.

Gold jumped 1.2% and is now trading near US$1,550 an ounce.

The Financial Review reports:

The ISM US manufacturing purchasing managers’ index fell to 49.1 per cent in August, the lowest since 2016. A reading below 50 per cent indicates the sector is shrinking.

The US index joins around 70 per cent of PMIs around the world that are now flashing warning signs, registering below 50, according to Morgan Stanley — a spread of negative readings unseen since the global financial crisis.

Let me show you how a little known market indicator called Dow Theory suggests this manufacturing contraction is set to get worse.

Dow Theory analyses both the Dow Jones Industrial Average and the Dow Jones Transportation Average together. The idea is to gain a deeper understanding into how the US economy is performing.

The gist of it is that the industrials represent the economy’s production while the transportation average indicates the distribution of this production throughout the economy.

Given this is an old theory, which came into action when the US economy was much less globalised than it is now, it has its fair share of critics.

But I believe it remains useful. That is, the industrials still broadly represent corporate America’s production capabilities, while the transports broadly represent its distribution capabilities.

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What the Dow Theory is telling us

With this in mind, let’s take a look at the two indexes and see what the Dow Theory is telling us.

First up — the industrials. While the index has gone nowhere over the past 12 months or so, it’s certainly been volatile. The green line is drawn from the early 2018 peak. Apart from a short-lived break higher a few months ago, this area represents broad resistance.

Dow Jones Industrial Average - DJI (WI) - 1 Day Bar Chart - USD - 4-09-19

Source: Optuma

[Click to open in a new window]

This chart tells you production in the US is in a bit of a holding pattern.

Now, if you look at the chart of the transportation average, you’ll notice that the chart structure looks very different.

To be specific, the difference only become pronounced in 2019.

As you can see, in 2018 the two charts look broadly similar. Both made tops in January 2018. After correcting, both rallied to marginal new highs in September/early October.

Dow Jones Transportation Average - DJT (WI) - 1 Day Bar Chart - USD - 4-09-19

Source: Optuma

[Click to open in a new window]

Following this trend, both the industrials and the transports crashed into a December low.

Here’s where things began to diverge. While both indexes rallied following that crash, the transports put in a relatively weaker rally. In fact, the transports made a series of ‘lower highs’, while the industrials broke out to new highs in July.

The late Richard Russell, who wrote Dow Theory Letters from the early 1950s until his death just a few years ago, would’ve noted this ‘non-confirmation’ as an ominous sign.

That is, when the industrials broke out to new highs in July, the transports weren’t even above the highs from April/May. For Richard Russell, this would’ve been a sell signal for the industrials.

As you can see, the transports are now clearly trending lower, while the industrials are still trying to maintain an upward trend.

Economically, what is this telling you?

In short, it potentially indicates that production has been running ahead of distribution and final demand. It means that inventories may be building across the US. As a result, production levels need to adjust lower to match reduced demand and ensure that inventories do not continue to build.

The slowdown in manufacturing activity tells you just that. And the Dow Theory suggests there is more to come.

This is further evidence of a slowdown in the US economy. The bond market has been predicting it for some time. But now you’re seeing it in the manufacturing numbers.

While we’re looking at charts, it’s worth noting the performance of the S&P 500 overnight.

As you can see, the structure is similar to the industrials. The green line, drawn from the January 2018 high, represents resistance.

S&P 500 Index - SPI (WI) - 1 Day Bar Chart - USD - 4-09-19

Source: Optuma

[Click to open in a new window]

Following the early August sell-off, the S&P 500 has been quite volatile. But as you can see, it hasn’t been able to break above that line of resistance. Overnight, the market rejected that level once again.

Given what I’ve just shown you above, this suggests the risks are to the downside for the S&P 500. From here keep a close eye on the 2,840–2,850 range. A break below 2,840 would be bearish and suggest further falls ahead.

To sum up then, it’s increasingly looking like a bear market is developing for the major US indices. And that spells trouble for the rest of the world and Australia.

If global equity markets do resume falling in the months ahead, expect Aussie interest rates to continue to fall.

We could be at 0.5% by Christmas…



Greg Canavan,
Editor, The Rum Rebellion

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Greg Canavan approaches the investment world with an ‘ignorance is bliss’ philosophy. In a world where all the information is just a click away at all times, Greg believes we ingest too much of it. As a result, we forget how to think for ourselves, and let other people’s thoughts cloud our own.

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