A Theory About Stocks Riding Waves

Photo by João Pedro Domingues/EyeEm/Getty Images.

While summertime means surf's up, some technical financial pundits are warning of a looming wipeout. According to some, a (Elliott) wave threatens to knock stocks off course. A century-old indicator is flashing warning signs, too. Should investors be concerned? In our view, no.^[i] Technical analysis commits the same fundamental flaw, regardless of the indicator: Patterns, levels and price points are arbitrary markers of past performance-they don't determine stocks' future direction.

The Elliott Wave-developed by Ralph Nelson Elliott in 1938-posits markets move in identifiable patterns known as "waves," with each wave a directional trend driven by repeatable, predictable sentiment patterns. We won't bore you with all the details-see MarketWatch's handy tutorial -but suffice it to say a bull market would have five "waves" and a bear would have three. A bull's five waves ebb and flow thusly: climb-pullback-climb-pullback-climb. Bear market waves follow a plunge-breather-plunge pattern. There are some other rules, like a bull's pullback can't erase an entire previous climb, but the broad brushstrokes are good enough for our purposes.

While we'll be among the first to agree stocks never move in straight lines, there is a teensy problem: A wave's definition is open to interpretation, and depending on your definition, the bull market that began in March 2009 could be in its 11^th wave-or it could be the fifth wave in a ginormous bull that began in 1990. Or some other things.

Even among Elliott Wave disciples, interpretations vary. One big Elliott Wave guru believes conditions-like extreme optimism and slowing of momentum indicators-are ripe for a market drop. Others believe we're near the end of the third and final wave of a bearish (or "corrective") wave-suggesting stocks should soon zoom. Some argue markets have been in a long corrective wave since 2000, pointing to the 2007-2009 bear market as confirmation that markets are in a "Grand Supercycle degree decline." Overlooking, of course, the 2002-2007 bull^[ii], when stocks gained 118%^[iii] and the current bull, which has returned about 250% and pushed US stocks far above their 2000 peak.^[iv] Staying on the sidelines rather than hanging 10 with the bull market seems like a costly decision for long-term investors.

For kicks, we tried to Elliott Wave our way through the last 25 years, and we gave up (Exhibit 1). We fared no better with this bull market (Exhibit 2). We are fairly certain this is all just a bunch of arbitrary searching for meaning in wavy lines.

Exhibit 1: S&P 500 Total Return Index Rides the Wave?

Source: Global Financial Data, as of 6/9/2015. S&P 500 Total Return Index, 12/29/1989 - 6/8/2015.

Exhibit 2: Current Bull Riding the Wave

Source: Global Financial Data, as of 6/9/2015. S&P 500 Total Return Index, 1/2/2009 - 6/8/2015.

The Elliott Wave isn't the only technical gauge making, er, waves-Dow Theory has also pushed its way into headlines, too. According to Dow Theory, the trends of the Dow Jones Industrial Average (DJIA) and Dow Jones Transportation Average (DJTA) will tell you where the market will go next. If both hit new highs (or have twin uptrends), you will get a great bull market. If the DJTA and DJIA experience a "significant correction"^[v] from new highs, one (or both) of the indexes fails to recover and then both indexes drop to their pre-correction lows, this all equals a longer downtrend for broader markets. How come? In the 19^th century, when Dow Theory was born, heavy industry and railroads dominated the economy. Falling transport stocks likely meant fewer goods shipped, which wouldn't bode well for industry. Rail stocks led many of the biggest panics back then. But the theory is outdated in our much broader, service-driven USA, where those antiquated price-weighted Dow indexes represent the narrowest sliver of commerce.

Today, the DJTA is down about 7%^[vi] for the year while the DJIA is up slightly and near all-time highs.^[vii] However, we suggest holding your horses-Dow Theory comes with its fair share of shortcomings, too. Shipping gauges are good economic barometers, but the DJTA is a limited one. Transportation stock prices don't always reflect the amount of goods transported. Airlines have taken it on the chin this year, yet air traffic is soaring! Shipping costs are down globally, threatening margins even as world trade rises. We think purer metrics like air freight volumes (up nicely year over year) and rail intermodal carloads (ditto) are more telling. Dow Theory also presents a logical disconnect. At its most literal, it would mean neither bulls nor bears would ever end. That's extreme, but it speaks to the folly of using index patterns alone. It relies on you to know which all-time high is the bull's ultimate all-time high. You can't get that based on price movement. When you compare the DJTA and DJIA to a well-constructed index-the market-cap weighted S&P 500 Total Return index, a better proxy for US stocks-Dow Theory's predictive power goes poof. (Exhibit 3-6)

Exhibit 3: Dow Theory's False Signals, 1982 - 1987

Source: Global Financial Data, as of 6/10/2015. Dow Jones Transport Average, Dow Jones Industrial Average and S&P 500 Total Return indexes from 12/31/1981 - 12/31/1987.

Exhibit 4: Dow Theory's False Signals, 1990 - 2000

Source: Global Financial Data, as of 6/10/2015. Dow Jones Transport Average, Dow Jones Industrial Average and S&P 500 Total Return indexes from 12/29/1989 - 12/29/2000.

Exhibit 5: Dow Theory's False Signals, 2002 - 2007

Source: Global Financial Data, as of 6/10/2015. Dow Jones Transport Average, Dow Jones Industrial Average and S&P 500 Total Return indexes from 12/31/2000 - 12/31/2007.

Exhibit 6: Dow Theory's False Signals, 2008 - Today

Source: Global Financial Data, as of 6/10/2015. Dow Jones Transport Average, Dow Jones Industrial Average and S&P 500 Total Return indexes from 6/30/2008 - 6/11/2015.

Both the Elliott Wave and Dow Theory commit the same broad forecasting sin: using past performance to predict future returns. Stocks look forward and price in all widely known information, including technical indicators and the beliefs and predictions they inspire. To the extent either ever worked, their predictive powers have long been sapped. Rather than looking at specific sectors and debating whether stocks are shredding some waves or about to wipeout, we suggest investors focus on things that actually matter for stocks. Like this.