Dow Theory, the Fiscal Cliff, and the Limits of Unlimited: Three Reasons for Investors to be Cautious – Published in Noozhawk on Monday, September 24, 2012

The recent rally from the lows set in early June, after the 11% correction we experienced from the April highs, has provided a 16.5% return for the S&P 500.  All three major indexes—The Dow Jones Industrial Average, the S&P 500, and the NASDAQ Composite—have achieve multi-year highs.  However, there are key reasons to believe that this rally may be coming to an end shortly.

Dow Theory

Dow Theory is based on Charles Dow’s insights into stock market analysis.  Dow was the founder of the Wall Street Journal and cofounder of Dow Jones & Company.  To Dow, a bull market in industrials could not occur unless the railway average rallied as well. He believed that, if manufacturers’ profits are rising, it means that they are producing more goods. If they produce more, then they have to ship more goods to consumers. It follows that the companies that ship the goods—the railroads at the time—must also be performing well. Therefore the market indexes for the industrials and the transportation companies should move together.  When the performance of the two averages diverge (move in opposite directions) it is a warning that a change in the direction of the overall trend is coming.

The chart below shows the past six-months of the Dow Jones Industrial Average and the Dow Jones Transportation Average.  The two indexes moved together through the middle of July.  Note that the recent market correction of 11% occurred from the end of April through the beginning of June and during that entire time, both indexes continued to move together with very high correlation—as one move up or down, the other moved in the same direction at the same time.

From mid-July, transportation stocks have performed poorly, while the overall Dow Industrial Average continued to charge higher, reaching multi-year highs.  During this same period, the broader indexes—the S&P 500 and the NASDAQ Composite—both also reached multi-year highs.

The Dow Transports are signaling a change in direction for the overall stock market.  The divergence between the Dow Industrials and Dow Transports is a clear indicator that this rally is about to end, and a correction is pending.  While Dow Theory is one of many predictive tools available to us, it has proven to be reliable over time.



The “Fiscal Cliff”

The Fiscal Cliff is the popular shorthand term used to describe the impact of the expiration of the Bush-era tax cuts at the end of 2012.  Congress can either let the Bush tax cuts expire, which will result in a number of tax increases along with some additional spending cuts that have been approved by Congress in other legislation, or vote to extend some or all of the tax cuts and/or delay the spending cuts.  If they don’t take action, the tax increases and spending cuts will weigh heavily on growth and could very possibly drive the economy back into a recession.  If they decide to extend the tax cuts and/or delay the spending cuts, the budget deficit will increase significantly, possibly causing a crisis similar to that which is occurring in Europe.

The Fiscal Cliff is a concern for investors since the highly partisan nature of the current political environment makes any compromise next to impossible. This problem is nothing new.  Congress has had three years to address this issue, but have been unable or unwilling to act.  Republicans want to cut spending and avoid raising taxes, while Democrats are looking for a combination of spending cuts and tax increases. Although both parties are aware of and want to avoid the Fiscal Cliff, compromise is seen as being difficult to achieve, particularly in an election year.

The most likely result is another set of stop-gap measures that would delay a more permanent policy change. The Congressional Budget Office (CBO) estimates that if Congress extending the Bush-era tax cuts and cancels the automatic spending cuts, the result, at least in the short-term, would be modest growth with no major negative economic impact.

If nothing is done, the effect on the economy could be dramatic. While the combination of higher taxes and spending cuts would reduce the deficit by an estimated $560 billion, the CBO estimates that the effect on the economy would be a reduction in gross domestic product (GDP) by four percentage points in 2013, sending the economy into a recession (a double-dip recession). At the same time, it predicts unemployment would rise by almost a full percentage point, with a loss of about two million jobs.  Just this past week, a Citi analyst predicted a 20% correction in stocks in a compromise cannot be reached that would delay the expiration of the Bush tax cuts and the spending cuts set to go into effect.

European Limitations

Mario Draghi, the head of the European Central Bank (ECB), recently stated that the ECB would do “whatever it takes” including buying an “unlimited amount” of sovereign debt of troubled countries within the European Union (EU) to avoid an economic collapse of the EU and the euro as a currency.  Although this statement was received very favorably by financial markets, the reality is that the ECB is strictly limited in what they can do.  In fact, the pool of money available to the ECB—the European Stability Mechanism (ESM) has only 700 billion euros authorized.  While this may seem like a lot of money (about $910 billion), there are multiple countries across the EU that are in dire straits and that must have bailouts to avoid defaulting on their sovereign debt.

The PIIGS—Portugal, Ireland, Italy, Greece, and Spain are the primary countries in need, out of the 17 full member countries in the EU.  There are many other countries, however, especially in Eastern Europe, that also need help to avoid financial ruin.

The ESM was established on the basis of each member country’s GDP—each country in the EU is responsible for a proportionate amount of the total 700 billion euros based on that country’s annual GDP.  For example, Germany, which has the largest GDP in the EU, is responsible for contributing 27% of the 700 billion euro total, or 190 billion euros.  The problem is (one of the many problems) that the PIIGS countries are also members, so they are also responsible for contribution to the ESM—the very pool of money that is to be used to pull these countries out of the financial abyss!  In fact, the PIIGS countries are responsible for 37% of the total, or about 260 billion of the 700 billion euros in the ESM!  This means that the PIIGS countries are supposed to pay 260 billion euros into the ESM, only to then take even more money back out.

Beyond the PIIGS countries, many of the other members will eventually need assistance in the form of a bailout, presumably to be paid out of the ESM.  The bottom line is that not only will the ECB not be able to buy an “unlimited” amount of sovereign debt to bail these countries out, but they are strictly limited in what they can buy, because they are in essence double counting money that the troubled countries are supposedly going to pay into the ESM when in reality, they can pay money in because they are the very countries that need to take money out!

The next few months will be critical for investors.  Gains that have been earned in stocks will be at risk as we advance towards the elections in November, the end of 2012, which brings the possible expiration of the Bush tax cuts and other spending cuts, and the realization that Europe’s problems will get a lot worse before they get better.  Investors must evaluate their investments in the context of these challenges and make portfolio adjustments accordingly.




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