Dow Theory - Market Phases
Primary movements have three phases. Look out for these general conditions in the market:
- Bull markets commence with reviving confidence as business conditions improve.
- Prices rise as the market responds to improved earnings
- Rampant speculation dominates the market and price advances are based on hopes and expectations rather than actual results.
- Bear markets start with abandonment of the hopes and expectations that sustained inflated prices.
- Prices decline in response to disappointing earnings.
- Distress selling follows as speculators attempt to close out their positions and securities are sold without regard to their true value.
Dow believed that stocks yielding below 3.5 percent where over-priced "except there be some special reason." Richard Russell analyzed the dividend yield on the Dow from 1929 to 1959 and found that the market tended to reverse when yields had fallen to between 3 and 4 percent.
Since the 1960s the dividend yield on the Dow and S&P 500 has declined to around 2 percent. We should be careful not to leap to the conclusion that the market is way over-valued. Examine the S&P 500 chart below and you will observe that the Dividend Payout Ratio declined over the same period, from 60 to 30 percent.
Companies are retaining a higher percentage of earnings, preferring to return capital to stockholders by way of share buy-backs rather than by way of dividends. This favors investors who prefer the enhanced earnings growth offered by share buy-backs, without the tax implications associated with dividends.
We should therefore switch our focus to earnings yield, rather than dividend yield, in order to avoid any distortion. An earnings yield of below 5.0 percent would offer a similar over-bought signal to a dividend yield of less than 3.5 percent (0.035/0.7=0.05). This translates to a price-earnings (PE) ratio above 20. I use a PE ratio above 20 to signal that a bull market is entering stage 3.
Increased volume on declines and dull activity on rallies provide additional evidence of an overbought market. Conversely, lack of activity on declines and increased volume during rallies indicate an oversold market. See Volume Patterns for further detail.