April 9, 2013 (5:30 pm)
We thought it would be interesting to review the Dow Theory. This is really a study in human psychology that, after more than 100 years, remains extremely relevant. The Theory consists of three trends (primary, secondary and minor), which are each split into three phases (accumulation, public participation and distribution). The timing of the trends is somewhat subjective, so let’s take a look at just the phases for now.
Phase 1: Accumulation. The accumulation phase is a period during which institutional owners (those in the “know”) are actively buying. The price remains relatively flat with little volatility, as these investors are in the minority absorbing shares that the broader market is supplying (i.e. buying from the less knowledgeable).
- Astute investors take new positions
- Volatility and volume are lower than average
- Sentiment is poor (and news is likely not favorable)
- Stock appears very bearish
Phase 2: Public Participation. The broader market (i.e. other funds, retailers, momentum traders) catches on and the price rises rapidly. Here, trend followers participate as the stock ascends and drive the stock to a speculative point.
- Volume picks up as technicians, retailers and momentum traders join in
- Investors become more confident in the stock
- Steady buying evolves into “frenzied” buying
- News becomes more optimistic
Phase 3: Distribution. Once the stock reaches the point of “rampant speculation”, the astute initial investors begin to distribute their shares to the broader market (i.e. selling to less knowledgeable investors).
- Optimism among investors is high
- News becomes almost completely bullish
- Astute investors begin distributing positions to less sophisticated buyers
APPLE INC. If we were to take a step back and analyze where Apple stands within the broader Dow Theory, it’s easy to conclude that the shares are in Phase 1 (accumulation). Volatility has been fairly low since its January 23 earnings report, as the shares have been range bound for the past ten weeks. Volume has also been steadily declining. Further, it’s easy to determine that the news has been almost completely negative with investor sentiment near all-time lows.
It’s also easy to conclude that last September defined the Public Participation phase. Retailers and less sophisticated investors were chasing the stock as it reached all-time highs. Instead of unloading positions, they continued to buy on the way down – in fact, it’s very likely that those investors (i.e. us and most of our readers) were buying from those institutions that recognized the distribution phase.
So What Comes Next? After the Accumulation Phase comes Public Participation. AAPL may actually be the definition of a stock that consistently undergoes a dramatic “Public Participation” phase. Many quick rallies have sparked massive runs, driving the shares up $100 or more in a matter of weeks. We’ve seen it time and time again. It just needs a catalyst (sometimes). We’ve all seen it. As investors become more confident in the shares, volume picks up and news becomes optimistic. Investors and traders fear they’re missing the run, so they jump on the bandwagon, driving the shares up higher into a frenzy. Buy when will that initial spark take place?
The Spark. We’ve been commenting on the chart below over the past few months. From our vantage point, the shares finally broke through the downtrend. Unfortunately, the shares fell right back through the trend line. It looks like a falling wedge (albeit a messy one), and the shares are now squarely within the wedge. It could keep falling to hit the lower trend line, or it could bounce back up. In other words, we don’t really have an edge.
But then we stumbled upon something new to us. We’ve always looked at logarithmic charts, since we expected that a percentage move was more important than a dollar price move for a high-priced stock like AAPL. But many traders and investors don’t. So we decided to take a look at the linear chart of AAPL. We may have found the spark. And that spark may be a technical breakout of the (much better-defined) falling wedge, along with positive divergence on the RSI during the highs as well as the lows.
The chart above is a beauty. Let’s quickly go through each aspect. The first is the green falling wedge, comprised of (a) the upper downtrend line that defines the entire six-month correction and (b) the lower downtrend line that begins at the May lows and continues through the lows formed a few weeks ago. The shares exploded through the upper trend line at $440 in late March and continued up $30 before losing a bit of steam. It’s now re-testing the upper trend line (purple arrow). This is clearly a crucial time for the shares. A breakout validates our analysis and very likely begins the “Public Participation” phase. A breakdown invalidates our analysis.
Importantly, we’re also seeing positive divergence here. The shares made a lower high in late March, but did so on higher momentum (RSI). Further, the shares re-tested the low of $419 on a significantly higher RSI. These may not sound like much, but let’s flip the scenario for a moment. Let’s think about negative divergence (higher high on price with a lower RSI). This is a very bearish metric that shows that momentum for a rally is declining and typically precedes a sell-off. Right now, we’re seeing the opposite of this dynamic. When you take this positive divergence along with the breakout of the falling wedge (and, hopefully, what will become a successful re-test of the upper trend line), we believe that the “Accumulation” phase and the AAPL bottoming process may be coming to an end. Phase 2 may begin sooner than many expect.