A Turn in the Tide in US Equity Markets
“A person watching the tide coming in and who wishes to know the exact spot which marks the high tide, sets a stick in the sand at the points reached by the incoming waves until the stick reaches a position where the waves no longer come up to it, and finally recede enough to show that the tide has turned. This method holds good in watching and determining the flood tide of the stock market.”
Written in 1901 by the founder and editor of the Wall Street Journal, Charles Dow, the opening paragraph explains his theory (Dow Theory) regarding how to read the primary trend of the US stock market.
On Tuesday evening last (4th March), Dow Theory gave a rare sell signal on the key US equity markets (or to be more precise, Dow Theory for the 21st Century – Jack Schannep’s version of Dow Theory). This suggests that there is a high probability that US equity markets are now in a downtrend.
Dow Theory is elegantly simple with three central principles of which the first is that there are three movements in the markets; the medium-term primary uptrend or downtrend, the secondary movements which are temporary movements against the primary trend and need to be watched in case they lead to a change in the primary trend and, finally, the daily movements which are irrelevant.
From mid-December 2024 to 10th January 2025 last, US equity markets encountered a secondary reaction against the primary uptrend as defined by Dow Theory (we won’t go into the specific rules here). From those lows, all three indices – the S&P 500, Dow Industrials and the Dow Transports – enjoyed a bounce of more than the required three per cent and over the required timeline of at least two days. But their recoveries did not hold and when S&P 500 Index and one other (in this case the Dow Transports Index) broke below their 10th January lows, a Dow Theory sell signal was triggered (the second of Dow Theory’s principles is that a lower low by the S&P 500 Index must be confirmed by either the Dow Industrials or Dow Transports).
Not all Dow Theory sell signals prove correct, so the signal simply increases the probability that a new bear market in US equities is underway. From 1950 to 2024 inclusive, a person religiously following Dow Theory buy and sell signals would have handsomely outperformed a Buy & Hold investor. This technical indicator’s main strength is that it has a history of successfully keeping investors out of deep bear markets.
I don’t make decisions based on the Dow Theory signals myself nor do we in GillenMarkets follow them for our investment clients. Nonetheless, we do find the indicator very useful for taking the temperature of the US equity markets, as the indicator offers an unemotional reading regarding whether these markets remain in an uptrend or have entered a downtrend.
With the S&P 500 Index trading on 28 times historic (GAAP) earnings, the most recent signal suggests that there could be considerable downside to this potential bear market. After all, from 1950 to 2024 the average that investors have paid for the S&P 500 historic earnings has been 18.4 times.
Many commentators point to the potential for Artificial Intelligence to boost growth. The trouble with this argument is that earnings on the S&P 500 Index have grown relatively consistently at circa 6 per cent annually since 1950 – GDP growth plus a bit. Paying 28 times earnings for medium-term annual earnings growth of 6 per cent is not my definition of good value; indeed, far from it!
If the valuation of the S&P 500 Index was to return to just the long-term average of 18.4 times historic earnings, the index would be trading at 3,864 today, and some 33 per cent below last Tuesday’s closing level. Throw in an economic recession driven by President Trump’s tariff policies and/or a reigning in of US Government overspending and one could get more bearish still.
On a positive note, looking back at the 2000 to 2002 US equity bear market, while the dot.com bubble led to a 45 per cent decline in the S&P 500 Index from peak to trough, many sectors that had been thrown by the wayside leading up to the peak of the Internet bubble in late-1999 did very well through that market downturn.
Could history repeat itself here? Many markets outside the US have significantly lagged the US equity markets over the past decade and trade on more reasonable valuations. They, too, may decline in price in a US-led bear market given that the dog (US equity markets) usually wags the tail. But permanent losses rarely follow when one has paid reasonable value for assets at the outset and has some patience.
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Rory Gillen
5th March 2025
GillenMarkets is an Irish-based Investment advisor, a provider of investment training courses and the publisher of Ireland’s only subscription-based investment newsletter.
