Monthly Discussion

What Does It Take for the DOW to Pick up Again?

This question was raised by a newsletter subscriber recently, which prompted me to give my answer in the form of a monthly discussion topic.

Understanding the DOW as an ecosystem involves studying the evolution of the share volume and the dollar value exchanged over DOW stocks (see An S-Shaped trail to Wall Street). In particular, we are trying to identify for these two variables natural-growth patterns (S-curves) that can be projected in the future. Forecasts for the DJIA will then follow from the ratio value/volume that gives the average DOW price weighted by the share volume. For the forecast of Exhibit 1 the ingredients dollar value and share volume can be seen respectively in Exhibit 3 (purple line) and Exhibit 4 (yellow line). Both exhibits depict the early parts of S-curves (practically exponential patterns).

Exhibit 3. Data and S-curve fit (purple line). The data points are daily.

The DJIA (and the average DOW price) results from a ratio and for it to increase either the numerator (dollar value) must increase or the denominator (share volume) must decrease. Since ratios are sensitive to small changes in the denominator, one way of achieving DOW’s turnaround is for the share volume to slow down its rate of growth even by very little. For example, the purple line in Exhibit 4 is constructed to resemble the natural fit (yellow line) but it features slower growth and results in an up-pointing DJIA (turquoise line in Exhibit 5). A small change in the trajectory of the share volume makes a significant change in the long-term forecast of the DJIA. Does this fact render the forecast unreliable?

Exhibit 4. Data and S-curve fit (yellow line). The purple line is a curve constructed to resemble the S-curve fit but cause an upward-pointing DJIA forecast. “True” volume refers to the share volume corrected for stock splits. The data points are daily.

Not really! The difference between purple and yellow lines in Exhibit 4 may seem unimportant, and eyeball judgment may consider either one satisfactory. But when my software program fits 12 years’ worth of daily data points it prefers the yellow-line solution. Moreover, there is a catch. The scenario for DJIA growth requires a toned down growth for the share volume but unchanged growth for the dollar value, which is rather significant.

Exhibit 5. Scenario for growth (see text). The drawing is the same as Exhibit 1 with the addition of the turquoise line.

To decrease the share volume while keeping the dollar value unchanged means that investors should play the same amount of dollars every day but distribute it in such a way that the share volume decreases. In other words, investors should progressively shift their portfolios to higher-price stocks. At older times, this would mean a shift toward high-capitalization blue chips since traditionally they enjoyed high prices. But recently the average DOW price has dropped exceptionally low. Not only newcomer technology stocks have ended up low-priced (e.g., INTC and MSFT) but also classic veterans of the high-price club such AXP, GE and JPM find themselves now at the low-price range following a number of splits and “rearrangements”. An upward turnaround of the weighted DJIA at his point requires a shift of dollar value from such stocks as INTC, MSFT, GE, T, C, MO, JPM and HWP to such stocks as MMM, JNJ, PG, IBM, MRK and XOM. This eventuality cannot be ruled out but this shift would have to persist long enough for the fit in Exhibit 4 to come out closer to the purple line than to the yellow one.

But how else can the DOW pick up again?

Besides the obvious way, namely that stock prices increase across the board—I let the reader appreciate this eventuality—there is also the possibility that our analysis treating the DOW as a species is no longer justified as of a certain date because the DOW underwent a major “mutation” at that date and became a different species. In such a case we should try to fit S-curves only from that day onward instead of since 3-Oct-1988. It is conceivable that fitting only the last few years’ worth of data, or say the last 15 months, could result into an up-pointing forecast for the DOW. But one must be able to defend such a decision. In my mind, the entry of INTC and MSFT is not tantamount to a major mutation, nor is the proliferation of stock splitting. Phenomena like this are commonplace in DOW’s history.

In lack of other arguments, I will put my bets on the long-term forecast as presented in Exhibit 1.