Technical Clues From An Uncommon Source: The Dow Jones Utilities
The Dow Jones utilities average is generally not considered one of the basic barometers of the stock market. While the industrials and transports are barometers in that their price action reflects the ebb and flow of future earnings, the regulated growth characteristics of the utilities lessen their significance as an overall barometer of future business activity.
The utilities average does have a special significance, though, as a barometer of interest rates. Since the utility industry has traditionally been capital intensive and highly leveraged, and with the shares affording yields competitive with fixed-income investments, the utilities are particularly sensitive to changes in interest rates. As the 1994 decline in overall stock prices is largely a result of interest rate tightening, some clues as to outcome may be afforded by the action of the utilities.
In terms of furthering an analysis of the stock market’s primary trend, a study of prior periods when interest rates were being increased to squeeze the economy might prove worthwhile. One such period with similar characteristics to today’s climate was the stock market’s extensive decline in 1984.
I’ll then narrow the focus and discuss the current technical trend of the utilities average, from an intermediate standpoint, as any change in the primary trend has to begin with a change of the intermediate trend moving from bearish to bullish.
The Market Decline of 1984
The economic climate in 1984, like today, largely reflected the cycle of monetary policy swinging from an accommodative stance to a more restrictive stance. The periods preceding 1984 were characterized by an aggressive easing of money, with the federal funds rate dropping from 18% in mid-1981 to just about 5% by mid-1984; over the same time period, the prime interest rate dropped from over 20% to 101/2%, and the discount rate was lowered from 14% to 81/2%.
While the overall interest rate levels were obviously much higher over that time period than today, the same aggressive infusion of liquidity into the system was as much in evidence then as had been the case until a few months ago. The result was a boom in stock prices, with the Dow rising from a 1982 low of 776.92 to a 1983 high of 1287.20. The move in more speculative issues, reflected by the Nasdaq index, was even more dramatic.
However, the same concerns that are present today were evident in 1983. The economy in 1983 was growing at a robust rate, and there was fear of re-igniting the inflation forces. The declining value of the dollar was of central concern, and it was feared that higher inflation would cause the dollar to collapse. As a result, the Federal Reserve decided to act to slow down the rate of economic growth and to dampen inflationary fears by increasing the cost of money; much the same reasoning was behind the Fed’s most recent moves to increase rates.
The federal funds rate began to move up in the latter part of 1983, and there was one increase in the prime rate in the third quarter. At the first of the year, the federal funds rate continued to rise, and during the second quarter of 1984, not only was the prime rate raised several times, but the discount rate was increased for the first time in well over a year.
The tightening of interest rates had its effect on stock prices. The Dow Jones utilities average topped out the first week in November 1983 at 140.70, starting a slide that would last over the next nine months, into mid-June, when the utilities bottomed out at 122.25.
Over the last two months of 1983 the industrials began to roll over. When in early February of 1984 key December support lows were taken out, a full-fledged panic ensued.
What had developed was two-fold: A market correction, but also a panic.
I make the distinction between a correction and a panic, since during most market corrections, stocks decline in more or less orderly fashion, then recover and move to new highs. However, following a panic, it takes time for the stock market to regroup.
I bring up this point given the “relief” in the markets that was supposed to occur when the Fed raised the discount rate on Wednesday, May 18, 1994: Supposedly, since the long-awaited boost in the discount rate finally had arrived, the “correction” was over and stocks were free to move back up; markets, though, do not operate in such a manner following panics, and take time to recover.
Back to 1984: Following the panic lows in mid-February of ‘84, the market appeared to have stabilized, although a look at newspaper accounts at that time would show investor concerns turning from fear of inflation to fear of recession. By April, the stock market began to appear healthier, with the industrials rising to new two-month highs. However, the inability of the transports in April to confirm the industrials did not bode well. Indeed, investors’ temporary sense of well-being was shattered in May, as the collapse of Continental Bank sent investors fleeing to the sidelines.
While the panic in May of ‘84 would cause many investors and advisers to pronounce “bear market,” the low in the utilities had already been seen. While all other market averages, and especially the more speculative ones, such as the Nasdaq, would move lower through July, the utilities began to trace out their first bullish minor sequence in months.
The minor move is more often than not the least useful of the trends of the market. However, any time an index, or a stock, for that matter, begins to trend higher after a long decline in a series of minor zigzags, the indication is very favorable.
During the week of July of 1984, the utilities moved to new six-week highs, unlike the rest of the market. The new six-week highs were not publicized in the financial press, but after an index that has shown the most pronounced weakness—and especially one that has been “leading” the other averages lower—begins to show strength, it is very notable. Important market turning points are typically characterized by divergences, and the utilities began to diverge by moving higher in July.
A further divergence developed the week of July 27, as a new wave of selling caused all other indexes to move lower. Most stocks plunged except, of course, for the utilities, which held above several prior lows, right at a support level as suggested by the June trading formation.
What the utilities were broadcasting to investors was that the concern over higher interest rates was beginning to wane. Bond prices were firming, and commodity prices and the price of gold were dropping sharply. The utilities were correctly forecasting the end of the reaction and the resumption of the bull market.
As an indication of how fickle, and somewhat unreliable, sentiment can be, take note of the next few weeks. During the last week of July in 1984, sentiment was extremely bearish, with all the major indexes with the exception of the utilities hitting new lows.
Yet, one week later, the week ending August 3, sentiment had turned wildly bullish, with an institutional buying panic sending stocks rocketing higher. The one-week gain of 87 points was unprecedented, and Friday, August 3, 1984, was the first 200-million-shares volume day in the history of the stock market.
The lessons to be learned:
• There is not a lot of courage of conviction in the stock market, and,
• Most of the gains and losses in the stock market tend to take place over a very short period of time, as the panic drop in February and panic advance in August both attest to. For this reason, you have to anticipate and not just react.
Whether the correction in 1994 will end quite as explosively as the one in 1984 remains to be seen. However, investors might look for clues that may signal the end of the decline, such as improving relative strength of the utilities, instead of waiting until it is “clear for all to see” that the bull market has resumed.
Intermediate Technical State
During the most recent market decline, the utilities average has dropped from a high of 256.46 on September 13 of last year to a low of 177.76 this past May 12, a 30.6% decline. While there remains some question as to whether the overall market is in a bearish phase, or just an extended secondary correction, the decline in the utilities has clearly been primary in extent and duration.
In terms of legs, the first leg of the decline was from the September 13 high of 256.46 to a low of 222.45 on November 15. The utilities rallied to a December 28 high of 231.48, then commenced to drop during the second leg of the bear trend to the May 12 low of 177.76.
One reading as to the intermediate technical state of the utilities average can be given by trend analysis. More often than not, many aspects of trend analysis, such as trendlines and channels, are not applicable for market declines, as the typical decline tends to move in almost an accelerating or down curving fashion, making trendline analysis unpractical. However, the conservative characteristics of the utilities, and the long-term holding goals in many accounts, has led to some interesting patterns.
Notice, for instance, that for extensive time periods during the declines, the downlegs have fit into fairly clearly drawn trendlines. During the decline from September through late October of last year the decline was orderly, until the last phase of the decline, the selling panic the first week of November, when stocks dropped sharply lower, breaking the channel or trendline to the downside.
Trendlines and channels can be broken in two ways. Most investors think of a trendline break as taking place either when an uptrend is broken to the downside, or when a downtrend is broken to the upside.
However, trends are in effect momentum, and the momentum of an uptrend can be broken with a stock pulling up and away from the uptrend, or the momentum of a downtrend can be broken with a stock falling sharply below its trend.
In the utilities average, the end of the decline during the first leg was characterized by the utilities falling sharply below the downtrend channel. Likewise, the sharp decline in May, with the utilities falling below the channel, probably signaled the end of the second leg of the bear trend.
From the lows of the May selling panic, the utilities rallied, with Friday the 13th the first day of the rally. The logical point for the rally to stall would be at the 190-192 level.
At first glance 190-192 represents the down trendline. However, trends form as the basis of support and resistance, and resistance at the April lows is really why the average would appear to be turned back at the downtrend. Trendlines do not form out of thin air, they form on the basis of support and resistance, and resistance at the April lows of 190-192 defines where and why the downtrend is drawn.
In any case, a bullish development would occur if the utilities rise above resistance at 190-192, thereby breaking through and above a resistance level for the first time in over six months.
The Individual Stocks
Previous readers of my articles in the AAII Journal know I have a penchant for low-priced stocks. Simply, the best gains stem from depressed and low-priced stocks, year in and year out. As some of the best opportunities in low-priced stocks arise when an entire industry is depressed, the extensive declines in the utilities provide some excellent potential.
As a group (see Table 1) the declines over the past year range from 18% to 45%. Every issue has shown its own particular degree of decline, and it would be advantageous to study the patterns individually.
What should you look for?
- When a stock has shown an extensive and well-defined decline, it is an excellent indication that the decline has run its course (at least for the time being) when the issue breaks the downward momentum by moving to the right.
- A second positive note would be a stock that not only declined from its highs, but has moved into a price range that is major support. Keep in mind that support levels are just that: levels, and not exact price points—it would be expecting a bit much for a stock to bottom out exactly at its previous panic low.
One criticism I frequently hear about technical analysis is that it is late; indeed, most of what is technical analysis as practiced by many today is late and not very useful to investors. But, support and resistance levels permit investors to anticipate, instead of just react.
The combination of (1) a stock beginning to find support, as would be indicated by the stock moving sideways at this juncture, breaking out of its bearish channel, at (2) a price level where support should develop, is one of the most bullish patterns in technical analysis.
That is what helps make investing in low-priced and depressed stocks so practical.