Lombardi: Stock Market Commentary & Forecasts, Financial & Economic Analysis Since 1986

Dow Theory Flashes Sell Signal

Wednesday, September 26th, 2012
By for Profit Confidential

The Dow Jones Industrial Average has risen more than 11%. And if I had to choose one reason to explain the rise in the world’s most followed stock market index, it is this: extreme (and unprecedented) money printing by the Federal Reserve and the hope that other foreign central banks will also print money. These are what have pushed stocks higher.

If you are familiar with technical analysis, then you probably have heard of Dow Theory.

Dow Theory is sending a warning to stock market investors and warning of a possible trend reversal.

Dow Theory simply states that the stock market is in an uptrend when one of two major Dow Jones components (the Dow Jones Industrial Average and Dow Jones Transportation Index) breaks above a previous high at the same time or close to the same time. This is also true in a downtrend.

The Dow Jones Industrial Average, consisting of 30 major companies, is currently seeing a robust move to the upside for stock prices. On the other hand, the Dow Jones Transportation Index, consisting of 20 major transportation companies, has been struggling, actually decreasing in value.

The following is the chart of the Dow Jones Industrial Average and the Dow Jones Transportation Index over the last 200 days.

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Chart courtesy of www.StockCharts.com

The Dow Jones Transportation Index and the Dow Jones Industrial Average were following each other very closely, a big positive under the Dow Theory. But near the beginning of July 2012, the averages started to go in opposite directions.

Since mid-September, these two main Dow Jones indices have been diverging. The Dow Jones Industrial Average has been rising, while the Dow Jones Transportation Index has been in a free-fall.

This divergence between these two averages should be taken as a big cautionary sign. The Dow Theory holds that, if the industrial companies are producing goods at a healthy rate, the transportation companies need to deliver those goods. We are currently seeing the Dow Jones Industrial Average rise and the Dow Jones Transportation Index decreasing—a sign of reversal.

Looking ahead, the outlook for the Dow Jones Transportation Index looks even duller. As I mentioned in these pages a few days ago, FedEx Corp. (NYSE/FDX), a component of the Dow Jones Transportation Index, has reported that earnings and revenue growth are slowing. Similarly, railroad stocks, which compose a fair part of the Dow Jones Transportation Index, are also witnessing a slowdown in business.

For example, Norfolk Southern Corp. (NYSE/NSC), a major railroad company, has lowered its estimate for corporate earnings for the remainder of the year due to challenging economic conditions.

Other railroad stocks, such as Union Pacific Corporation (NYSE/UNP) and Kansas City Southern (NYSE/KSU), have also seen their stocks plunge. This is mainly due to lower coal and grain freight. Coal production has decreased 6.1% in 2012 because of the lowest coal consumption in 20 years. (Source: NASDAQ, September 14, 2012.)

What does this all mean?

The divergence of these two important Dow Jones indices is a cautionary sign. Could the stock market be rising on nothing but thin air? I’ve been suggesting this for months.

Michael’s Personal Notes:

Gold bullion prices have been hovering a little below $1,800 an ounce. As I have been writing, the price chart and demand for gold bullion are still suggesting a bullish outlook for the shiny yellow metal. Year to date, gold bullion has gone up 13.4%.

Thanks to more money printing, the U.S. dollar, which was considered a foreign reserve currency by about 60% to 65% of world central banks (used to be 70% to 75%) is quickly becoming a liability for foreign central banks.

To counter the decreasing value of the U.S. dollar against other world currencies, foreign central banks are taking measure to devalue their own currencies in order to stay competitive. Unfortunately, in most cases, this can only be achieved by printing more of the respective country’s currency.

Gold bullion is currently the only form of currency that is stable, can’t be produced out of thin air, is in limited availability, and has a good store of value. Hence, foreign central banks are buying more of it and gold bullion will continue to shine.

Central banks do not make an announcement before they go out in the markets to buy gold bullion. They report after the purchase. Why? It’s because they want to buy without increasing the price of gold bullion. If one follows the tracks of central banks’ purchase pattern for gold bullion, one can be certain that they are on a buying spree.

Institutional investors in gold are going into this sector and buying after being on sidelines for a while. Gold bullion holdings by institutions have gone up 7.7% to 178,426 contracts for a five-week straight advance. (Source: Bloomberg, September 24, 2012.)

To bring the demand for gold bullion into perspective, the U.S. central bank is the biggest holder of gold bullion. It holds 8,133.5 tons of gold bullion in its vault; compared to China which only has 1,054 tons of gold bullion. The U.S. holds 75.4% in gold bullion compared to 1.7% in holdings for China. (Source: Kitco, September 24, 2012.)

Keep in mind that China has the world biggest foreign reserve of U.S. dollars—a little more than $3.0 trillion at beginning of 2012. (Source: Bloomberg, January 13, 2012.) What are the chances China will buy more gold bullion? Very high, if you ask me.

I’ve been bullish on gold bullion since 2001 and nothing has changed in the gold markets to alter that opinion. Actually, world events as they are unfolding, all that money printing and debt, are just making me more bullish on gold bullion.

There are fundamental reasons behind the current rise in gold bullion prices and speculation is not one of them. Central banks are running towards the yellow metal and will continue to chase it until there is stability in the current global economy. I’ve been saying it for all of 2012: there is great opportunity with the stocks of junior and senior gold-producing companies.

Where the Market Stands; Where it’s Headed:

The Dow Jones Industrial Average has lost a couple of hundred points over the past three trading sessions. The euphoria over the Fed’s latest round of money printing is dissipating. Focus is sifting back to the weakening global economy and the credit crisis in Europe. We are near the end of the bear market rally in stocks that started in March of 2009.

What He Said:

“I’ve been pushing gold bullion and gold shares for over a year now. Back in January 2002, I personally started buying gold shares.” Michael Lombardi in Profit Confidential, December 13, 2002. Gold bullion was trading at under $300.00 an ounce when Michael first started recommending gold-related investments. Many gold stocks recommended in Michael’s advisories gained in excess of 100%.

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Michael Lombardi - Economist, Financial AdvisorMichael bought his first stock when he was 17 years old. He quickly saw $2,000 of savings from summer jobs turn into $1,000. Determined not to lose money again on a stock, Michael started researching the market intensely, reading every book he could find on the topic and taking every course he could afford. It didn’t take long for Michael to start making money with stocks, and that led Michael to launch a newsletter on the stock market. Some of the stock recommendations in Michael's various financial newsletters have posted gains in excess of 500%! Michael has authored and published over one thousand articles on investment and money management. Michael became an active investor in real estate, art, precious metals and various businesses. Readers of the daily Profit Confidential e-letter are offered the benefit of the expertise Michael has gained in these sectors. Michael believes in successful stock picking as an important wealth accumulation tool. Married with two children, Michael received his Chartered Financial Planner designation from the Financial Planners Standards Council of Canada and his MBA from the Graduate Business School, Heriot-Watt University, Edinburgh, Scotland. Follow Michael and the latest from Profit Confidential on Twitter or Add Michael Lombardi to your Google+ circles