The majority of investors and market commentators seem to believe that we are in a new bull market in equities. Admittedly the rise of more than 60% for the FTSE and 80% for the Dow from the March 2009 low is a pretty big move, but as the great Dow theorist Robert Rhea points out, these counter-trend moves are often mistaken by the public as being a new bull or bear market.
Dow theorists believe that what we have seen since the low of 3,530 for the FTSE and 6,626 on the Dow is nothing more than a bear market rally within a much longer-term secular bear market. According to Dow Theory every bull and bear market has three separate phases, each of which is separated by a counter-trend rally.
Phasing: The anatomy of a bear according to Dow Theory
To illustrate the phases of a typical bear market let’s look at the 1966 to 1974 bear market in the Dow.
I have marked on the three phases of the decline (red arrows), each of which is followed by a rally (blue arrow) separating the declines. Phase I of the bear market began at the top in February 1966 and was confirmed by Dow Theory in May of that year. The Phase I decline of 25% ended in October 1966 and was followed by a 26 month rally – at which point many investors were convinced stocks were in a new bull market.
In December 1968 the 17 month Phase II decline began taking the market to new lows and falling some 36%. Then came the rally separating Phase II from Phase III, a 32 month advance of 66%. Again many were convinced a new bull market had begun, especially since the market had made a new nominal high.
Having taken the market down 45% the Phase III decline that ended in 1974 marked the end of the bull market. Sentiment at the time was extremely bearish and the public wanted nothing to do with stocks – a condition typical of market bottoms. In December 1974 the market made its low and began a new bull market – a call made by Richard Russell, another Dow theorist – which took stocks all the way to their eventual top in October 2007.
Why March 2009 was not the end of the bull market
History shows us that typically a bear market lasts around one-third the length of the preceding bull market. The 1974 to 2007 bull run lasted 34 years, therefore the bear market should last around 11 years, taking us to 2018. The 2009 low however, occurred only 17 months after the 2007 top.
Another reason Dow theorists think we haven’t seen the low for this bear market has to do with the historical relationship between the dividend yield and the price earnings ratio. These tend to be roughly equal at the end of a secular bear market at around 7. At the 2009 low the P/E was 26 and the dividend yield was around 3.
A warning from history
Dow Theory has served its followers well in the past, protecting them from some big market falls – Sell: Sept 1999, Buy: June 2003, Sell: Nov 2007 and Buy: July 2009 – therefore despite the popular view that we are in a new bull market, investors would do well to remember their history.