A cornerstone of Dow Theory is confirmation. Dow Jones used industrial and railroad indexes as indicators of the state of the economy and business. Confirmation is the process of comparing two averages, to assert the direction of the primary trend. What this means is that if the one index reaches a new high, yet the other index doesn’t, it means the primary trend is running out of steam. If one index reaches a new high, then the other index should also, around the same time. They don’t need to reach new highs or lows at exactly the same time – a few weeks is acceptable. The primary and secondary indexes should perform together. If not, a divergence suggests a reversal is likely.
The secondary index should complement the primary index. The secondary index should also consist of securities that are completely different from those in the primary index. For instance in Dow’s time he used the industrial and rail indexes. Today the modern version of the rails index is the transportation index. The American transport index is the Dow Jones Transportation Average. On the Johannesburg Stock Exchange (JSE), the equivalent index is the Industrial Transportation Index (INDT – Black Line Chart).
If we compare the JSE’s Top 40 Index (TOPI – Blue Line Chart) with INDT, we can clearly see that the Top 40 reached a new high on 20 June 2007, yet INDT failed to reflect this peak. On 6 March 2008 another divergence occurred, when the Top 40 reached another new high, and INDT continued its downward trend. On 22 May 2008 the Top 40 reached its all time high, and the INDT yet again told us otherwise.
What can we say about the past 5 months? Well it looks as if the Top 40 is trending sideways, and INDT is continuing its downward trend. This is yet another divergence. Not as strong as the ones produced during 2007, and 2008, but still suggesting that the Top 40 might fall even further than its lowest point on 20 November 2008. It looks like the Top 40’s current support is around the 16000 to 16800 range. On the 3rd of March 2009 INDT reached an all time low, but TOPI has not yet reached an all time new low. I believe there is a strong likelihood that the TOPI will continue trending downwards during the next 6 weeks, and reach a new low. It will be interesting to see if this is indeed the case.
What’s so powerful about Dow’s confirmation is that it provides a strong early warning signal that the big trend is changing. In the recent past we were warned almost a year before the JSE finally came crashing down.
Many people have asked why the South African Rand is so weak currently, when the financial crises is primarily a western problem. I think there are several factors that is causing the Rand weakness (and please let me know if you think there are any that I’ve left out, or that you think is incorrect):
- Investors are in dire need of cash. The credit crunch is forcing them to sell whatever assets they have in order to salvage their cash flow. This is maybe another reason gold has struggled to surge over a $1000 per ounce. All the leverage that the previous housing bubble provided is being removed from the markets.
- Investors are pouring their money into the traditional de facto safe haven asset that is US government bonds (treasury bills and notes).
- Hedge funds need to sell assets as clients take their money out of these risky funds, that often stops short of almost gambling with their money.
- A long list of stop losses are unwinding, which triggers a new wave of selling.
Looking at point 2 it should be clear not to underestimate the importance of bonds, and especially government bonds, during a bear market. During a strong bull run, like we’ve had over the past 5 years on the Johannesburg Stock Exchange (JSE), nobody tends to take notice of them. But when the bears arrive, bonds become an ever important asset that should definitely take up a larger part of one’s portfolio.
In South Africa investors have a few options to trade bonds and bond based securities:
- Trade in the spot market on the Bond Exchange of South Africa (BESA) or the JSE’s Yield-X.
- Trade in the futures market on Yield-X.
- Trade in the options-contract market on Yield-X or Justrade.
- Trade in Investec’s Zshares GOVI Exchange Traded Fund (ETF) on the JSE itself.
It is Investec’s Zshares GOVI ETF that I’d like to introduce here today, as it will enable small investors to gain exposure to the bond market. The GOVI ETF saves you the time and effort of opening another trading account at a bond broker since it’s traded on the JSE, and from R10 per “share” you gain access to the bond market. Zshares GOVI will list on the JSE on the 21st of October 2008. As the name suggests it tracks the total return of BESA’s GOVI index of government bonds.
Zshares GOVI has the following characteristics:
- No cash distributions are made, since all coupons and bond maturities received on the underlying government bonds are automatically reinvested by acquiring additional bonds in the same proportions as the index constituents.
- Total Zshares GOVI Return = Price Performance of underlying bonds + Reinvested coupons and bond maturities + Fees earned on any bond sale and repurchases (ie: repo’s).
- It’s an ETF and units trade live on the JSE.
- All underlying government bonds are bought and sold on BESA or Yield-X.
- Transparent index methodology.
- Portfolio rebalanced in line with GOVI index rebalancing.
- Transparent portfolio composition. The fund’s composition is available on Investec’s Zshares web site.
- Trade settlement guarenteed by the JSE, making it a very safe investment.
- Very importantly it has a very low cost: The annual management fee is 0.2% to 0.25%.
This is a wonderful tool, that will give small investors an easy way to make bonds a part of their portfolio.
Investec Bank (INLP)
As a moderately eager income investor, I like keeping a few preference shares in my portfolio. One share I have been watching over the past 5 months is Investec Bank’s preference share (INLP) on the JSE. Currently it’s the 8th highest dividend payer on the JSE, based on historical dividend payments. It was recently priced at R78, with a P/E of 1.38 and a Dividend Yield (DY) of 13.12. Its chart is indicating an oversold position, without any indication of a turnaround, so it will most likely become even cheaper. R78 is also its current support level, and I expect it to trade sideways for a while.
I believe South African banks are very solid, and should weather the financial storm relatively well. Regardless, they’ve become part of the global fire sale of stocks. INLP is a non-redeemable, non-cumulative, non-participating preference share. Personally I prefer to invest in cumulative preference shares, so that the dividend payments are guaranteed (unless of course in the situation that the company goes bankrupt). So that’s the only disadvantage I can see with this share. But with a P/E of 1.38, and technical indicators predicting that number to shrink even further (although I’m no expert in technical analysis), you can’t go wrong to put in your bid for it when the trend changes into a bullish one (which could be a long time from now).