THE DOW PSYCHOLOGY

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Monday, Oct 06, 2008
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The Dow psychology
GUEST COLUMN
Mukul Pal / New Delhi October 6, 2008, 0:53 IST

A global marketplace means that investors will link the performance of Sensex with that of the Dow. So far, the correlation is not proven


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The first time I heard somebody keeping a track of Dow on a day-to-day basis was a business school senior of mine from the class of 1997. Little did I know that in matter of barely over ten years, the world will get glued to Dow daily and intraday movements.

And nothing will matter more than where the Dow was headed. We are in the age of the Dow, and Dow psychology rules. The grip is so powerful that an emerging market broker in Romania after a market update to his client starts talking about what the client is interested in most, the bailout meeting. The respective client will be missing the UEFA championship match between CFR Cluj and Chelsea to watch the bailout meeting at home.

Dow is the global pastime now. Before 2000, it was both Dow and the Nasdaq. After the tech bust, Nasdaq featured less in inter office bets and perceived connections with Indian markets.

NOTE: DOW AND NASDAQ ARE BOTH FAMOUS IN THE INDIAN MARKET.

I also remember another occasion when even a shoe shine boy understood, where we are headed tomorrow was more due to the Dow. The perceived connection was thought to be an unstated rule. On occasion when markets took a different turn locally compared to what the Dow was doing, news of a decoupling between global and local markets featured in national newspapers and TV channels. There was always a reason why a Dow connection worked or weakened at times.

As time passed and both liquidity and number of investors increased, the forecasting rules were simple, if there is certainty and up move it is generally because of local factors, but when uncertainty comes in it is the Dow.

It did not matter whether over a month and quarter what Dow returned in terms of price changes, what mattered was the daily and weekly volatility in the price performance of the benchmarks. There were not many studies I read since 1996, which actually studied correlation between Dow and the Sensex or other emerging market indices and whether such comparisons really made sense.

Even fundamental analysts historically have taken refuge in this fact suggesting an upside as a predictable certainty and downside as the Dow effect. The correlation between the Dow and the Sensex are poor. Rather correlation itself increases and decreases as markets move from greed to fear. At both extremes, the correlations have been known to be high. This is why during contagions every market seems to be correlated.

Going a bit deeper into correlations between the Dow and Sensex suggests a historical correlation of 0.69, for the last decade it has been at 0.64, the highest correlation has been since 2002 lows at 0.90 which has fallen now to 0.82 if you look at just the last year. I just ran a random check to see if the correlation could just go negative.

And here I was at the first attempt – 0.42 from May 26, 2005 to Oct 19, 2005. Correlations are an illusion that we live in, as you can actually draw a cycle of increasing and decreasing correlations between Dow and Sensex. And what use is correlation anyway. Correlation as a trading indicator works miserably with not much back testing validations.

And if we just extend the relationship to Dow and dollar, which are seen to have stronger correlation, a strong dollar and positive Dow move together. Even here the correlations between Dow and dollar can go awry cyclically, positive correlation today and negative tomorrow. It just does not work.

Once you identify that the correlation is increasing you know the assets are in sync and vice versa. It is like the classic outperformance underperformance intermarket cycles we have talked about. There will always be a period the Dow will outperform Sensex and a period when it will underperform. Just to look at one side of the cycle is extrapolation and ignoring the other side by calling it decoupling is human.

Dow is our psychological alibi that we use to explain market vagaries. There is no other way you can explain why, if the problem is in America, did China, Russia, India and the world fall more than the Dow. Of course, there will be some explanation for this too.

But then, how quantifiable is it? We at Orpheus believe that emerging markets are better indicators and lead the Dow. India formed the primary low on September 21, 2001 months before the October 8 low of Dow in 2002. Indian and Chinese indices may have lagged at the current top, topping after the October 11, 2007 high in Dow, but emerging markets like Romania had topped as early as July 24, 2007. This is why the Dow psychology remains flawed.

Even if the Dow psychology works better when inverted, understanding American markets remain important in terms of understanding when does psychology hit an extreme? Markets take more time to bottom than they take to top. This is why 'V' shaped patterns are seen more at the top than at the bottom. The Dow breaking at 10,000 will be globally watched and discussed.

What is more relevant is not 10,000 but the support zones near 9,700-10,000 levels. The 10,000 level is more psychological than real. The 9,700 level is the previous primary low and 9,900 is the key 0.618 Fibonacci level of the up move since October 8, 2002. After six years we are back once again to the October symmetry (the Oct low), which the Dow has been repeating since 1932.

Like we said last time, markets have not broken an October low since the great depression. So, though the term great depression is used pretty loosely now, we have yet to pass the major October confirmation.

Bank failures, bankruptcies, 30-70 per cent collapses in indices all seem to be culminating in the anticipated time window ahead. Many indices including the Dow are falling in seven wave structures. This means classic corrective zigzags. Seven waves are corrective structures not impulsive move downs.

Though we understand that seven waves could be extending into nine waves impulsive, which have a more bearish aspect linked to it, the extreme volatilities on many indices suggest otherwise. Many emerging market indices have spiked with 10-year high volatilities suggesting that panic is total and global now. Prices are also nearing the previous four wave conventional supports on some indices, Oil and gold still under supply pressures, dollar continues strength, it is too early for us to let go of the October low hypothesis.

We are in the age of Dow or simply putting the age of global psychology, which does not understand that markets have a limit till where they can collapse unlike the proverbial moon where it can go on the other side. We are in the age of too much information, this is why summaries excite us more than books, and herding is more convenient than trashing the Dow effect.

The Dow composite, just a week back, was the top performer among global indices. So, Dow might have some catching up to do till 10,000 and maybe marginally lower. But, to expect 8,000 in the next few weeks seems a low probability scenario to us.

We are looking at the Japanese Nikkei now, which should give us our first cues regarding potential multi-month global bottom formations in October and not the Dow. Let's see.

The author is CEO, Orpheus CAPITALS, a global alternative research firm
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