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The 2008 Financial Crisis


Dow Theory and the 2008 Financial Crisis

Dow Theory and the 2008 Financial Crisis; picture of two investors discussing the Dow theory and how the stock market crashed through the floor during the crises

As investors learn more about the cyclical nature of the financial markets they naturally begin to wonder when this current bull market cycle will end. There are a variety of market analysis techniques investors can use and one of the oldest is known as Dow Theory.

Dow Theory is one of the market analysis techniques used by StockInvesting.today to determine the likelihood that the current bull market has ended.

The purpose of this article is to show investors how Dow Theory can determine the end of a bull market cycle. Since the current bull market is still intact, the previous bull market which ended October 2007 will be analyzed. The end of the previous bull market lead to what is now known as the '2008 Financial Crisis'. This was one of the severest bear markets in many decades and is shown below in Chart 1.

Chart 1. DOW Industrial chart

Dow Theory and the 2008 Financial Crisis - dow theory Chart for the industrial averages index showing the market crash

This severe bear market caught a lot of investors of guard as they were not equipped to deal with such a financial crisis.

Dow Theory can alert investors to a possible bull market reversal and is a simple principle to use which can be summarized as follows:

Dow Theory:

  1. The DOW Industrial Index must make a high, pullback to make a low, rally and then sell down below the pullback low.
  2. The DOW Transport Index must do the same as the DOW Industrial Index, although the action does not need to be identical.

The charts for the DOW Industrial and DOW Transport indices are shown below which illustrates how Dow Theory determined the market top.

Chart 2. DOW Industrial chart

Dow Theory and the 2008 Financial Crisis - dow theory Chart for industrials showing how the market crash could have being avoided

Chart 2. above shows how the DOW Industrial Index made a relative high (first RH on chart), then pulled back to make the relative low (RL), then rallied to make another relative high (second RH on chart) and finally traded down through the RL.

Chart 3. DOW Transport chart

Dow Theory and the 2008 Financial Crisis - dow theory Chart showing the transport how it reacted when the market crashed a few weeks later

Chart 3. above shows how the DOW Transport Index made a relative high (first RH on chart), then pulled back to make the relative low (RL), then rallied to make another relative high (second RH on chart) and finally traded down through the RL.

Referring to the above charts, the conditions for a Dow Theory market reversal signal are satisfied. Note that the second relative high does not need to be higher than the first - which was the case with the DOW Transport Index. Also the 20-day moving average is a useful tool to help locate the relative highs and lows as this helps to highlight the short-term trends.

The 2002-2007 bull market officially peaked in October 2007. The investor using Dow Theory was given a market reversal signal during November 2007 which was about six weeks after the market top. By then both the DOW Industrial and DOW Transport indices had traded below their respective relative lows suggesting that a market reversal was possible.

Certainly those investors who acted on the Dow Theory signal given in November 2007 managed to get out very near the market top and avoided the significant sell down in stock prices that occurred during 2008.

Dow Theory is best viewed as being an alert indicator - that is it alerts the investor to the possibility that this might be the end of the current bull market cycle. Dow Theory is like a fire alarm and all fire alarms can ring even though there is no fire. The question the investor needs to ask themselves is it better to exit and be safe or do you stay and take the risk.

A practical use of a Dow Theory signal is to act on the signal only while the DOW Industrials trades below the RL line. If the DOW Industrials trades above the RL line there is an increased likelihood that the Dow Theory signal is a false signal and the investor can consider re-entering their positions..

No market analysis technique is perfect and all will give some false signals. Dow Theory tends to work best when the markets have been trending for some time - in other words Dow Theory is pretty good at picking the tops of bull markets that have been climbing for many years. Dow Theory does not work so well when markets are broadly consolidating over the years. The reason for this is that Dow Theory is essentially a trend following indicator and like all trend following indicators they do not work properly in consolidating markets. Also Dow Theory tends to be better at locating market tops than with market bottoms. The bottom of bear markets often have a strong rebound rally which means Dow Theory tends to be late at giving a reversal signal.

Earnings and the 2008 Financial Crisis

Earnings and the 2008 Financial Crisis; picture of an earnings declining trend with the arrow point downwards during the crises as stock prices fell during the crash

The stock market is essentially driven by investor sentiment. These investors are seeking significant capital gains and their focus is on the future earnings potential of listed companies.

During buoyant economic conditions it is relatively easy for companies to increase their profits every quarter, however when adverse economic conditions arise their profitability can take a hit. These companies are now reporting substantially lower quarterly earnings and this shakes the confidence of investors who are normally optimistic. These investors are now pessimistic and their mentality is that of shoot first and ask questions later. The fear of mass bankruptcies looms in the back of investors minds.

The stocks in the S&P 500 index are the larger companies and their quarterly earnings are tracked by investors. Should the quarterly earnings decline sufficiently; this can cause investors to lose confidence and abandon or at least reduce their holdings.

The total weighted quarterly earnings for the S&P 500 companies is shown below in Table 1. for the years leading up to the financial crisis of 2008.

Table 1. S&P 500 Quarterly Earnings

Earnings and the 2008 Financial Crisis - Table showing the SP500 Quarterly Earnings up to the crises

The quarterly earnings for the S&P 500 companies are weighted based on their market capitalization. This means that the larger companies contribute a greater percentage to the total index earnings.

Historically there is a chance that a bear market will develop when the quarterly earnings decline by more than 15%. The decline in Table 1. above was over 30% for third quarter in 2007.

The earnings shown in Table 1. can be plotted on a graph which visually highlights the earnings trending nature.

Graph 1. S&P 500 Quarterly Earnings

Earnings and the 2008 Financial Crisis - Graph shwoing how the SP 500 Quarterly Earnings dropped right before the crash

The earnings are plotted from the fourth quarter in 2002 which was the start of 2002-2007 bull market. The 30.8% decline in earnings for the third quarter in 2007 gave investors advanced warning that the bull market may have come to an end. At the very least it allowed investors to reduce their holdings.

The earnings data takes around two months to accumulate for the reporting quarter. This is because the companies' accountants need time to produce their reports - which takes from a couple of weeks to a couple of months. Some companies are fairly quick and release their quarterly results within two weeks but other companies are slow and it takes them two months.

Analysts produce earnings estimates for the future quarters in advance. At the end of the quarter all the earnings are just analysts' estimates. By the second week after the end of the quarter some companies release their earnings - now there are some actual earnings mixed with the analyst estimates from the companies that are yet to release their earnings. By the ninth week after the end of the quarter all the companies have now released their earnings.

So for the third quarter (which ends 30-September) the earnings reports for all the S&P 500 stocks are received by the end of November. This means that investors would have known that the 2007 Q3 quarterly earnings declined by 30.8% at the end of November 2007.

This timing compares favorably with the November 2007 warning signal that Dow Theory gave. Having the Dow Theory warning signal supporting the earnings decline warning certainly made a strong case that the bad times were just around the corner. The rest is now history!

The S&P 500 quarterly earnings and Dow Theory are some of the market analysis techniques used by StockInvesting.today to determine the likelihood that the current bull market has ended.

Economy and the 2008 Financial Crisis

Economy and the 2008 Financial Crisis; picture of the economy crashing downwards during the 2008 crises with investor holding his hands against his head in disbelieve

The more savvy investor is always on the look out for any signs that the current bull market might have ended. Technical based analysis such as Dow Theory and earnings based analysis such as the S&P 500 quarterly earnings were explored in previous articles. These showed that investors were given a warning signal in November 2007 that the previous 2002-2007 bull market may have come to an end. The Financial Crisis that followed in 2008 certainly left investors' gob smacked as to the severity of the market sell down.

Another strategy investors use to analyze the current market conditions for the likelihood of a market reversal is to analyze the economic data. Some like to use forecast economic data but this article will focus on analyzing the official economic data that was released.

1. Gross Domestic Product

The trend leading up to the 2008 Financial Crisis is shown below in Chart 1. for the real (inflation adjusted) GDP.

Chart 1. Gross Domestic Product - GDP

Economy and the 2008 Financial Crisis - Quarterly GDP Chart gross domestic product showing how the crises was affected for that period

The Shaded area on all the FRED charts highlights the official recession period which is from 01-Dec-2007 until 01-Jun-2009. It should be noted that the official recession start date is usually determined well after the recession actually started.

The GDP for each quarter is released in three stages over a three month period. From the GDP chart the earliest an investor would have noticed that the economy is struggling would have been the 2008-Q1 report. But the final revised report for 2008-Q1 is released some three months later. To really consider that the GDP growth has contracted would not be known until the 2008-Q3 report. But the final revised report is released around the end of 2008.

This means using the GDP reports has a significant time delay. While the GDP reports are useful for trending purposes they are not a timely source of data.

3. Industrial Production

The trend leading up to the 2008 Financial Crisis is shown below in the monthly Chart for the Industrial Production Index.

Chart 2. Industrial Production

Economy and the 2008 Financial Crisis - Industrial Profits Chart showing how it was impacted by the market crash

The Industrial Production report is a monthly report which is released a couple of weeks after the reporting month. This report shares a lot with the GDP report but is a timely report which is far more useful for locating adverse economic conditions.

The Industrial Production Index showed its weakness by the April 2008 report (The report is released around two weeks later).

The Industrial Production Index can also be viewed as the percentage increase from a year ago rather than the actual index values as shown below in Chart 3.

Chart 3. Industrial Production (%change year ago)

Economy and the 2008 Financial Crisis - Industrial Profits Chart shown as a percentage change from one year ago for the same period as above chart 2

The format shown in Chart 3. is useful in identifying possible recessions. Negative year ago percentage gains highlight economic weakness and investors should even be cautious with percentage year ago gains of less than 1%.

The early warning sign that the economy might be weakening occurred with the March 2008 report which showed that the Industrial Production Index over the last year increased by only 0.6%. The index went negative with the following months April 2008 report indicating that the economy had weakened.

5. Nonfarm Employees

The trend leading up to the 2008 Financial Crisis is shown below in the monthly Chart for the Nonfarm Employees.

Chart 4. Nonfarm Employees

Economy and the 2008 Financial Crisis - nonfarm employees Chart showing how the number of people employed by businesses fell during the financial crises

The nonfarm employees report is another monthly report which is released about a week after the reporting month. This report is another timely report which is quite useful for locating adverse economic conditions.

The nonfarm employees Index showed its weakness by the May 2008 report (The report is released around a week later).

The nonfarm employees chart can also be viewed as the percentage increase from a year ago rather than the actual number of employees. This format is shown below in Chart 5.

Chart 5. Nonfarm Employees (%change year ago)

Economy and the 2008 Financial Crisis - nonfarm employees Chart show again with percentage change from one year ago for chart 2 shown above

The format shown in Chart 5. is useful in identifying possible recessions. Negative year ago percentage gains highlight economic weakness and investors should even be cautious with percentage year ago gains of less than 1%.

The early warning sign that the economy might be weakening occurred with the August 2007 report which showed that the nonfarm employees Index over the last year increased by 0.9%. The index went negative with the May 2008 indicating that the economy had weakened.

Summary

All of the above economic indicators showed that the economy was heading into a recession during 2008.

The GDP is the least useful economic indicator as it gave the latest signal.

Both the Industrial Production and Nonfarm Employees indices are were more effective. The Nonfarm Employees year ago percentage change actually gave the earliest caution signal in August 2007.

The Dow Theory and the S&P 500 quarterly earnings still provided the earlier signal in November 2007 that the 2002-2007 bull market may have ended.

Forecasts and the 2008 Financial Crisis; picture of a road sign with a dollar sign warning that the forecast economy is deteriorating quickly as it crashes down

Forecasts and the 2008 Financial Crisis

The Securities Industry and Financial Markets Association (SIFMA) produces an economic outlook report twice a year. The reports are derived from the opinions of securities firms, banks and asset managers.

The purpose of this article is to see whether these economic outlook reports gave investors any indication that the 2002-2007 bull market was coming to an end and that a severe bear market was waiting for investors in 2008.

Economic Outlook - Mid 2007 report

Highlights of the economic outlook for the second half of 2007 and for 2008.

Mid 2007 report:

  • The pace of U.S. economic growth to accelerate after the slow first quarter through the balance of the year and into 2008.
  • The median forecast anticipates GDP growth of 2.2 percent for full-year 2007 and 2.8 percent in 2008.
  • Growth is expected to increase from the anemic 0.6 percent rate in the first quarter to 3.2 percent in the second quarter, 2.6 to 2.8 percent during the second half of 2007, and 2.9 percent in the first half of 2008.
  • Nonfarm payrolls will increase by a total of 1.6 million annually in 2007 and in 2008.
  • Business capital investment is expected to tail off this year to 3.7 percent, recovering to 5.0 percent in 2008, but still lower than the more robust capital spending growth rates of the last few years.
  • The median forecast projects the Fed funds rate will remain at 5.25 percent over the next year.
  • Panelists agreed that the S&P 500 index level at the end of 2007 would be above the current level and reach record territory. The S&P 500 will be at 1,575 by year-end 2007, according to the median forecast, which would represent a better than 10 percent increase from the year-end 2006 level of 1,418.

From the above highlights, the Mid 2007 report gave no indication that the economy would fall into recession in 2008. The forecast actually had a decent GDP growth in 2008 as well as increasing the Nonfarm payrolls by 1.6 million.

Economic Outlook - End 2007 report

Highlights of the economic outlook for 2008.

End 2007 report:

  • The pace of U.S. economic growth to slow in the first half of 2008 but pick up in the second half of the year.
  • The median forecast anticipates GDP to grow but at a below-trend pace of 2.1 percent in 2008 as the economy works through the housing sector contraction and the effect of credit market turbulence.
  • Growth is expected 1.5 percent in the first quarter of 2008 to 2.1 percent in the second quarter and 2.5 percent to 2.6 percent during the second half of 2008.
  • The majority of the panelists expect the FOMC to continue to cut rates through the first half of 2008. The median forecast has the Fed funds rate at 3.50 percent at the end of the second quarter.
  • The median forecast calls for consumer spending to increase by only 1.9 percent for full-year 2008.
  • Nonfarm payrolls increasing by about 1.06 million annually in 2008.
  • Growth in business capital investment is expected to slip modestly from 4.6 percent in 2007 to 4.4 percent in 2008, but will be much lower than the more robust capital spending growth rates of recent years.
  • The panelists agreed that equity values will rise in the coming year. The median projection is for the S&P 500 to reach 1600 by year-end 2008, which would represent approximately a 9 percent increase from level at the end of the survey period.

From the above highlights, the End 2007 report did acknowledge that there was credit market turbulence.

The forecasts were for GDP growth rather than contraction and the Nonfarm payrolls to increase rather than decrease. There was also an expectation that the S&P 500 index would continue to increase rather than the violent sell down that occurred.

In general the economic outlook reports failed to foresee the severity of the economic contraction yet alone the stock market crash of 2008.

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