Is The Dow About to Take a Steep Turn South

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It is noteworthy to say the least that the Dow Jones(DJI) is experiencing a tough year despite early gains.  With Deutsche Bank reducing full year EPS growth for the S&P 500((SPX) to negative, a first for banks in 2015 – the floodgates for downgrades might have just been unleased as corporations struggle with a stronger dollar and stumbling global growth.  The outlook is not pretty for US corporates as headwinds build between a shaky global economy and weaker American consumer power.  Based on the latest consumer data, it is not surprising to see even consumer staple companies affected even though they are normally more resilient during downturns.

Buybacks Fueling Gains

The main driver of higher prices in the last few months has been corporate buybacks which have buoyed earnings numbers despite top line growth that leaves a lot to be desired.  With companies shifting the focus to earnings from revenues, capital expenditures have been falling.  It infers that companies have borrowed to fund EPS growth at the expense of growing their underlying business.  On top of this, companies have increased their leverage by borrowing the very money to issue buybacks.  This brings up a much stronger question of corporate culture and how it has become mis-incentivized, but the shell game of raising earnings cannot work permanently, especially if interest rates rise and balance sheets meet their breaking point.  While bonuses are high for executives, the underlying businesses have been trimmed to such a degree that finding any organic growth will be difficult at best.

DOW

Just a quick look at the component aspects of the Dow Jones Industrial Average shows a mere 12 of 30 of listed companies are trading in positive territory year-to-date.  The vast majority of components are negative, led lower by major losses in the technology sector, consumer staples, energy, and financials markets.

A true bellwether stock for this index is the multinational heavy machinery company Caterpillar which has been truly decimated by the slowing pace of global economic activity coupled with a stronger dollar.  With all company exports becoming increasingly expensive on a backdrop of weak trade and investment, 2015 does not look to be the year of recovery for the company’s fortunes.  Technology stalwarts Intel and Microsoft also revising guidance lower for the coming quarters is not a good sign, with each trading -14.77% and -10.91% lower respectively in 2015.

The Technical Take

From a purely technical perspective, the Dow Jones Industrial Average is rapidly approaching several various longer-term levels of importance.  As displayed on the chart below, although still trading above its 50-day moving average, the difference is quickly narrowing, with any move to the downside possible confirmation of further weakness.  Still, the benchmark index is substantially higher than the 200-day moving average, implying no present shift in trend.  The uptrend line currently intact since October of 2011 remains similarly important as no major correction has occurred due to the distortions of quantitative easing.  However, although new all-time record highs were seen as recently March 2nd, momentum has slowed while volatility has picked up dramatically in the last few sessions.  The absence of a major correction make it all the more likely and coupled with the fundamental outlook, increasingly probable.

DOW Image 2

With the dollar continuing to ascend despite the policy headwinds preventing higher interest rates, every subsequent strengthening makes the US benchmark equity indices markedly more expensive.  Moreover, it continues to devastate international sales volumes as exported goods become more costly abroad.  Coupled with the slowdown in consumer spending and lacking appetite for credit, there are several reasons to be concerned about the present equity market valuations.  Although buybacks have supported prices to a point, the latest downward revisions to guidance, revenues, and earnings are concerning considering their implications.  The lacking investment in the last few years is likely to hurt corporates seeking to recover from weaker revenues as they find it more difficult to borrow down the road once higher interest rates kick in.

DOW image 4

The Big Picture

In the coming weeks it will be worthwhile to watch the Chicago Board Options Exchange VIX Volatility Index as any sharp move higher will likely be indicative of a flight to hedge against uncertainty in equities.  A lot is also set to change as Apple, the world’s largest company by market capitalization, will be added to the Dow Jones 30, replacing AT&T which has been a legacy of the Dow since 1916.  However, it needs to be noted that historically changes to the index have not necessarily been positive for the new additions.  Typically shares gain ahead of the inclusion in the stock index before it sells off after the addition.  There may be a silver lining as typically, Dow additions have traditionally risen 3% relative to the S&P500 (SPX) meaning more upside in the index could be possible before any sharp correction lower.

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