Dow Theory Triggers Bear Market Alert

Dow Theory Triggers Bear Market Alert





A major bear market signal was triggered on November 21st.

Developed by Dow Jones co-founder Charles Dow and perfected by
investment writer Richard Russell, the Dow Theory is a popular
technical indicator among market participants dating back to the late
19th century. When major averages such as the Dow Jones Industrials and
the Dow Jones Transportation Average move in the same direction, the
markets’ long-term trend is identified. And starting last week, the Dow
Jones Industrials Average (DJIA) finally confirmed the Dow Jones
Transportation Averages (DJTA) previous bear market signal earlier this
summer.

If correct, the current bear market signal could imply the DJIA and
other U.S. and international averages are heading at least 10% lower
over the next several weeks – the first bear market since March 2000.



Economy Sluggish in late 2007

Since hitting an all-time high on July 19th, the DJTA has tumbled
20.4% as signs continue to point to a broad-based U.S. economic
slowdown.

The Transports are a reliable indicator of the economy’s direction
because they include cyclical companies tied to the movement of goods,
including railroads, truckers, airlines and freight companies; when the
economy stumbles, this average usually feels the pain first as shipping
orders decline and freight volume decreases. But until last week, the
mother of all global indexes, the DJIA had defied the Transports’
weakness hitting all-time highs until October 9th.

From its high last month, the Dow now sits 9.8% off its best level
and marks the second time since August that it has tested previous
lows. Since March 2003, the Dow has not declined more than 11% from its
highs amid a period of unusually low volatility until earlier this year
when signs of sub-prime stress first struck the market.

Other Averages Also Deteriorating

Along with the Transports, smaller company stocks have also been hit
hard this year and trail the broader market for the first time this
decade.

Since hitting all-time highs last summer, the Russell 2000 Index has
plunged 13.6% as investors continue to bail-out of risky small stocks
and swap exposure for the more defensive large-caps in the S&P 500
Index and the Dow 30. But even these larger companies are taking a
beating lately as investors flee just about everything, except gold
stocks.



Overseas Markets No Safe-Haven

Despite its declining influence and smaller share of total global
stock-market capitalization, the United States still sets the
short-term trend for the majority of world markets.

And the old adage remains true: “When Wall Street sneezes, the rest of the world catches a cold.”

Market pundits have been quick to claim that Asia and other emerging
markets are now “decoupled” from the United States’ economic cycle.
Nothing could be further from the truth. Despite losing pre-eminence to
financial centers in London, Frankfurt, Shanghai and Hong Kong this
decade, New York still radiates loud and clear on any given trading
day. Asian markets follow Wall Street’s trend overnight and European
bourses open the next day on the heels of New York’s closing trend. If
you need proof, market returns in November rank as the worst month for
investors since September 2002; the MSCI World Index has tanked 8%
while the MSCI Emerging Markets Index has stumbled 11.4%. Even with a
weaker dollar again this month, foreign currency denominated stocks
have declined in-synch with U.S. averages offering no safe-haven.



Recipe for a U.S. Rally in 2008

I’m probably a lone wolf on this forecast, but I want to reiterate
why I think American large-cap stocks, including the financials, will
rebound in 2008 along with the majority of foreign markets.

Think lower interest rates, an extremely competitive U.S. dollar,
decent corporate earnings and at some point, sharply lower oil prices
in 2008.

A secular bear market is unlikely to develop because the classic
signs of a monetary squeeze are simply not in the cards. Previous
recessions and bear markets were the result of Federal Reserve monetary
tightening; the Fed is now on course to cut interest rates even further
into 2008 to halt the deepening mortgage-backed crisis and the severe
bear market in housing. Lower rates will put on a floor on earnings and
the stock market. Provided employment doesn’t fall off a cliff, the
economy will recover by mid-year.

The best way to play that imminent recovery is to buy large-cap
multinationals, including the beaten-up banks. Though I expect more
sub-prime related write-downs in 2008, the market is getting very close
to discounting a tidal wave of bad news. Also, with U.S. equity mutual
fund sales at a negative $19.9 billion this year, a major contrarian
signal has surfaced for the bulls. Individual investors are notoriously
wrong at market-timing.

Finally, as oil pushes through $100 per barrel and beyond over the
next several weeks, I expect a major correction in the primary trend.
Too many speculators are riding this bull and a major shakeout is
looming.

Lower Oil would be Bullish for Stocks

Oil prices are undoubtedly in a secular bull market this decade as
supplies remain historically tight, OPEC can’t boost production further
and tensions remain in the Middle East. But the market is placing too
much faith on China’s consumption; crude oil prices do not reflect a
weakening American economy this quarter and over the next six months.
At some point, a vicious correction looms. A major decline in crude
prices would boost consumer sentiment and jolt the stock market higher.
I remind investors that even in a bull market, commodities can suffer a
bad year. Oil declined in 2005, despite commencing a secular bull run
in late 2001. Also, in a Presidential election year, I suspect the
government will do all it can do influence lower crude prices,
including releasing supplies from the Strategic Petroleum Reserve.

We might be in a bear market in late 2007. But I think it’ll be a
short-term decline, however painful, that will eventually lay the
groundwork for another big rally over the next several months as the
Europeans, Canadians and Asian central banks join the Fed and start
cutting lending rates to boost economic growth. Stay invested.