The battle cry in the stock market recently has been to sell bonds and buy stocks. The thinking is that stocks are a far better buy right now than government bonds on a relative valuation basis. Given that bond yields continue to sit near generational lows (even after the recent spike), this certainly makes sense. However, one of the questions investors may be asking themselves these days is, "can I really buy stocks at these levels?"
Lest we forget, the bulls have been in control of the stock market since March 10, 2009. Since that day when the banks announced they were making money, the S&P 500 has moved up an impressive +84%. And in light of the fact that the average bull market since 1900 has produced gains of approximately +81%, investors might be correct in thinking that now may not be best the time to blindly jump into the stock market.
To which, the Dow Theory says to forget about your fear and “Buy ‘Em!” You see, on November 3, the venerable Dow Theory issued a fresh buy signal as the Dow Jones Industrial Average moved above its April highs. While there is a fair amount of debate on what exactly constitutes a Dow Theory signal, history shows that such buy signals have been quite profitable.
According to Wikipedia, the Dow Theory is based on a series of 225 editorials written by none other than Charles H. Dow. Following Dow's death, William Peter Hamilton, Robert Rhea and E. George Schaefer organized and collectively represented "Dow Theory," based on Dow's editorials. The purpose of the Dow Theory is to confirm the direction of the “primary trend” in the stock market.
In simple terms, the trading system is based on the idea that once the Dow Jones Industrials and the Dow Jones Transports have issued confirmed buy signals, the trend is up – and will stay up until a Dow Theory “Sell” is given.
So how does the market get a Dow Theory Buy signal? In the simplest of terms, our understanding of the system is that after both the Industrial and Transport indices have put in a bottom (think bear market bottoms) they will rally. Eventually, this rally will lead to a correction (producing a “higher low” in the process). Assuming the ensuing rally exceeds the previous high and is confirmed by both indices, a buy is flashed.
Confusing? Yes, a little. But basically the idea is for the indices to rally, correct, and then move on to new highs. And it is after a confirmed rally to new highs that the Dow Theory give the “all clear” signal.
While there are many problems with the system, not the least of which is that the recent signal would be the first buy signal given since the 2008 sell signal, history shows the signals to be a fairly reliable and profitable guide. For example, according to Ned Davis Research, six months after a buy signal, the DJIA has been higher in 90% of all cases and has sported a median gain of +11%.
Another way to look at the productivity of the Dow Theory approach is through a market timing lens. The computers at NDR show that since mid-1970 if one had bought the DJIA on Dow Theory buy signals and gone to cash on sell signals, you would have handily beaten the buy and hold approach.
For example, from 5/1/1970 through 12/15/2010, if one had implemented this approach with the DJIA, they would have produced an average compounded rate of return of 8.5%. This is obviously higher that the 5.2% per year of the buy-and-hope approach.
I know what you’re thinking; a difference of 3.3% year may not be worth the trouble. But let’s do the math. If one had started with $10,000 and invested it in the DJIA, they would now have $77,918 after 40+ years. However, by following the Dow Theory Buy signals and going to cash on the Sell signals, the account would be worth $272,210. And this is why the call compound interest the ninth wonder of the world.
While this may sound well and good, there is one very important caveat to consider. In short, the Dow Theory requires more than a little subjectivity when trying to identify the signals. Some have argued that the most recent Buy signal occurred on November 3rd, while another interpretation suggests that December 10th was the appropriate buy point.
In any event, if you are looking for an excuse to move some money into equities for the next six months, now you’ve got one. Actually, you’ve got several. In addition to the Dow Theory buy, there is the calendar. There is the traditional year-end rally which is generally followed by the “January effect.” In addition, history shows that buying in November and holding through April has proved to be a very profitable venture.
Next up on the list of reasons to be long going into 2011 is the Presidential cycle, which is also favorable through the second quarter. And finally, there is the “cyclical bull within a secular bear” cycle, which, as you might have guessed by now suggests that the market should rally in the first part of next year. (P.S. We’ll provide more detail on all of the cycle work over the weekend.)
S&P 500 - Last 5 Years
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