Market Analysis

Dow Theory

The Dow Theory is a method of market analysis that has been popular and widely utilized for over a century. Developed by Charles Dow, the Dow Theory examines and predicts market trends. In accordance with this Theory, when one of the Dow’s averages increases above a noticeable high, then the market is in an upward trend. There are six main principles of the Dow Theory. First, the Dow Theory relies on the Efficient Markets Hypothesis (EMH). The EMH declares that a security’s price incorporates all variables and components of the market. Secondly, the Dow Theory operates under the belief that there are three different types of market trends. The first two, bull and bear markets, are commonly known and understood; however, the Dow Theory believes in a third trend that results from drawbacks in a bull market or advances in a bear market. Thirdly, the Dow Theory understands each primary trend to have three phases. A bullish market has an accumulation phase, a participation phase, and an excess phase. A bearish market has a distribution phase, a participation phase, and a panic phase. The fourth principle states that market averages must validate each other. In other words, the signals provided by one index must match the signals provided by another. If they do not match, an investor should assume that the signal given is false. The fifth principle of the Dow Theory asserts that volume needs to confirm the trend. Low volume levels indicate market weakness while high volume levels indicate market strength. Lastly, the Dow Theory strongly believes that trends will continue in the same direction until an obvious reversal occurs. In other words, an investor should not rely on secondary trends.

When first created, Charles Dow stressed that his Theory was not perfect. Rather, it was simply designed to provide guidelines for investors and traders. Dow was moved to create his Theory due to the number of investors who interacted with the market on the basis of their emotions. When he was alive, he greatly stressed the importance of observing the market with objectivity alongside basic, formulaic principles. Thus, Dow created the Dow Theory to provide a simple methodology for examining the market that was mostly not up for interpretation. The Dow Theory is not perfect, but it has performed incredibly well when put to the test. From 1929 to 1998, the Dow Theory was used to indicate moments to enter and exit the market. Over this 70-year time frame, the Dow Theory out-performed the buy-and-hold strategy by around 2% each year. For many investors and traders, the Dow Theory’s performance was a remarkable accomplishment. However, it has its faults. Over the past 18 years, it has underperformed the market by 2.6% each year. Nonetheless, it has only been a near two decades of underperformance. Over a much longer length of time, the Dow Theory might outperform the buy-and-hold strategy. All in all, the Dow Theory has been an extremely popular and successful Theory utilized by many traders and investors. It is important to acknowledge its potential shortcomings, but its emotionless methodology provides a way to interact with the market that contains less risk overall.

Intermarket Analysis

The basic principle of Intermarket Analysis is that what happens in what market most likely affects another market or a couple of other markets. Thus, Intermarket Analysis is a market analyzation tool that examines the relationship between four different asset classes: stocks, bonds, commodities, and currencies. The correlations between these four asset classes primarily illustrate the strength or weakness of the market or asset class in question.

The simplest form of Intermarket Analysis arises from a correlation study where the values fluctuate between -1.0 and +1.0. To do this, a trader would need to compare one variable to another separate variable. A correlation result of +1.0 produces a perfectly positive relationship between two assets, while a result of -1.0 represents a perfectly negative relationship. As the values inch closer to the zero line, the possibility of there being a relationship between the two variables becomes slimmer and slimmer. Obtaining a perfectly positive or negative correlation that has any significance is quite rare. Thus, most investors use +0.7 and -0.7 as benchmarks. Values over +0.7 or below -0.7 that are sustained for a relatively long period of time illustrate significantly positive or negative relationships between the two chosen variables. Another key component of Intermarket Analysis is that it depends on inflation or deflation levels. In what is deemed a normal inflationary environment, stocks and bonds will show a positive correlation. Conversely, in a normal inflationary environment, the relationship between bonds-commodities and currency-commodities will be inversely related. The U.S. economy has also witnessed to long periods of deflation. During deflationary environments, the relationships between bonds-commodities and currency-commodities remain inversely related. However, during these deflationary periods, the relationship between stocks-bonds reverses to join the others as it becomes representative of an inverse relationship. The only relationship that exhibits positivity during a deflationary period is the relationship between stocks-commodities.

The main principle of Intermarket Analysis is that markets change in accordance with outside variables that lay within other markets. This tool of market analysis can be incredibly useful for medium-long term traders as the data derived from Intermarket Analysis only becomes more secure with time. It does have potential drawbacks, though. Large economic events such as a recession can rupture the logical relationships between asset classes for an extended period of time. The situation does not have to be as dire as a recession; Intermarket Analysis can be subjected to various economic environments that crumble the relationships between asset classes. Thus, this form of market analysis should never be employed alone. In fact, most traders have found that it works drastically better when utilized alongside other tools of technical and fundamental analysis.

Yield Curve

A Yield Curve is a tool of market analysis that plots yields, also known as interest rates, of bonds with varying maturities. On a chart, the yields are represented on the vertical axis, while the maturity of the bond is represented on the horizontal axis. There are three basic shapes a Yield Curve can take: upward sloping, downward sloping, or flat. Upward sloping Yield Curves are considered “normal” while downward sloping yield curves are considered “inverted”. The slope of a Yield Curve usually illustrates market health and potential future yields. For example, an upward sloping Yield Curve signals market health and expansion, while a downward sloping Yield Curve represented market weakness and a potential recession. Usually, an investor would expect a higher return on long term lending, such as a period of two to three decades. On the other hand, if an investor is only lending for a few months, they can expect to receive a lower return. In accordance with this, an upward sloping Yield Curve signifies that the short-term rates are lower than the long term rates, thus indicating a healthy, normal market. A downward sloping Yield Curve signifies that the short term rates are higher than the long term rates, thus signifying an unhealthy, inverted market. A flat curve simply means that the long term and short term rates are valued at roughly the same percentage. Yield Curves can also change shape over time by either steepening or flattening, which can at times accurately signal future changes in economic conditions. Usually, when a Yield Curve steepens, a period of economic growth and expansion is indicated. On the other hand, when a Yield Curve begins to flatten, the economy might be on the road to recovery. Overall, the Yield Curve is a useful and beneficial tool of market analysis that can shed light on future economic conditions as well as indicate where an investor is within the market cycle. As with all tools and indicators, the Yield Curve should not be employed alone to understand market health.