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Weighing a Dow Theory signal

Friday 14 December 2007 06:40PM

In case you missed it, there was an important technical signal from the US stock market on November 21st. After days of flirting with just such an outcome, on that day the Dow Jones Industrial Average finally closed below its August 16th lows, something that the Dow Jones Transportation Average had done two weeks earlier.

This, according to Richard Russell, the best-known living advocate of Dow Theory, means that the US stock market has now entered “a primary bear market”.  This is an important signal that is only confirmed, according to the originators of Dow Theory, when the two venerable market averages (industrial and transport) have both breached their previous lows of the year. (Sceptics might wonder how relevant any theory based on two such unrepresentative indices can be in predicting general market movements, but that is another matter).

Of course, this being technical analysis, some of whose exponents are more slippery than a bar of soap, the signal does not mean that we will not get a traditional end-of-year market rally, as the indices were already “heavily oversold” after the hefty declines that characterised most stock markets in November. What it does appear to mean however is that investors are now in a market whose underlying trend from here is down, not up.

Nobody could claim that this is implausible call, albeit that the same Mr Russell was only a few months ago declaring that we were entering the final spectacular phase of a great multi-year bull market. His response, in common with most technical analysts who appear to change their views radically, will no doubt be to invoke the spirit of Keynes, who famously declared when accused of inconstancy in his opinions: “When the facts change, I change my mind. What do you do, Sir?”

The problem of course is that technical analysis, which often aspires to the status of a science, is in reality only scientific in the narrowest of senses. Yes, it involves the analysis of empirical data, namely the price history of markets and securities, but its real value lies in the quality of the interpretation, and that is ultimately subjective, rather than scientific.

The worst technical analysts are invariably those who are rigidly reliant on theoretical rules to the exclusion of judgment and common sense.  The most enduring and popular, amongst whom I would certainly include the estimable Mr Russell, combine the wisdom of years with an open mind. To make a career out of marketing daily market commentary, as he has done since 1958, it helps to have a warm personality and, not least, a sense of humour.

The nearest thing that the UK has to a Richard Russell in age and experience is probably Brian Marber, who has been selling his market views, and his own more combative brand of humour, for more than 50 years.  His verdict on his chosen profession as a technical analyst is uncompromising: “Anyone who tells you it’s a science is a charlatan, or con-artist, not a chartist”.

The truth, he adds, is that “All indicators work some of the time; none of them work all of the time”. Prescriptive theories such as The Elliott Wave (“ a great way to predict the past”) are useless for that reason, while day-to-day forecasts, being based on too short a data sample, are “rubbish”.

The best technical analysis, in his view (as in mine), is valuable precisely because charts have no feelings. To the extent that they represent the balance of supply and demand amongst investors, they provide a useful counterpoint to the emotional, perceptual and behavioural factors that undoubtedly move markets, in the short term at least. It is no accident, surely, that technical analysis works best in foreign exchange markets, where short term trading - and therefore sentiment - account for the overwhelming majority of transactions.

Mr Marber has no time for volume as a technical indicator, for this reason. As he points out, there are no volume figures to work on in foreign exchange markets, which is where over the years he has found the biggest market for his services. If technical analysis works best in a market that gets by without volume figures, it is hard to believe, he points out, that they can add much value when analysing other types of market.

His best market calls have invariably been those that “nobody can remember”.  This is because they have usually been made at big market turning points that his clients, for whatever reason, were simply not prepared to believe. When he called the bottom of the great 1972-74 bear market on January 8 1975, for example, one of his former partners at N.M. Rothschild declared that he “always had been mad”.

I suspect that Mr Russell will have had similar experiences.  In a world where Bloomberg TV, CNBC and other market channels churn out an unending stream of market opinions, many of them contradictory, confirmation bias remains a daily hazard for all professional investors. Opinions that challenge comfort zone thinking can still be worthwhile, even if they are based on technical indicators that have no scientific value or even, as too often in technical analysis, a clear and unambiguous meaning.

“Thinking” concludes Mr Marber “is what causes the really big losses. Why not let the market do the thinking for you? Stick to interpreting”.  Even if you do not go as far as Mr Russell in announcing a primary bear market, the stock market has certainly been saying lately that it is fearful. The alternative interpretation, which is that the Federal Reserve and other central banks are being bounced by desperate bankers into unnecessary and premature interest rate cuts, looks less credible as each day passes.

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