In today’s writeup we cover the important fundamental topic of Dow theory. In this we will also cover the breakdown of Dow bottom and its impact on our portfolio decision making thought process.

Let us first of all revise our current scenario. We have latest dow top of 18255.75. Our dow bottom is at 16985.2

Source: Trading View

Our current P/E ratio for nifty 50 index is at 21.42.

Source: NSE India

Our 10 year government of India bond rate is at 6.75%, so our P/E ratio for fixed income instrument is around at 14.817~15.

Source: Investing

So we are now well equipped with our data points, let us revise some of the concept of Dow theory before the actual update. This time our main focus would be to write specifically about the mindset of Investors who are already in the market and if they are already in the market then what should we do. We will try to write as well from the mindset for people who are out of the market and what they should do now.

Although we have talked in the past on how to identify recent significant top and bottom, but let’s again revisit these concept in quick recap.

How to identify significant bottom(Valley)?

We need two parameters:-

1. Width:- Should be more then 31 days(≈ 4 weeks),

2. Depth:- Should be more then 4%, in valley we measure Depth by looking from top to the bottom (visualising as seeing a pool of water from the surface and measuring it’s depth).

So, if we look further:

POINT A:- Recent significant top, which was on 18th of October, 2021 at the 18338.55 level,

POINT B:- Lowest point after A, which was on 13th of December, 2021 at 16985.2 levels,

POINT C:- Highest point after B, which was on 7th January , 2022 at 17812.7(closing).

So our dow bottom is at 16985.2

How to Identify Significant Top(mountain)?

We need two parameters

1. Width:- Should be more then 31 days

2. Height:- Should be more then 4%, in mountain we measure height from bottom to top(visualising as seeing a mountain from the bottom)

So, if we look further:

Point A:- Recent significant bottom, which was on 13th December at 16985.2 level

Point B:- Highest point after A, which is at 10^th January, at 18255.75 levels.

Point C:- Lowest point after B, which was 24^th January at 17101.95.

So our recent significant TOP is at 18255.75 Level.

Now, if we look our P/E ratio of fixed income which is at 15(approximate). We can have a look at the P/E ratio ranges:

Low range: PE<20

Mid-range: PE 20-27

High range: PE>27.

Coming to the juicer part of the write-up where we will discuss the breakdown of dow bottom in this recent time. In the last 2 years we have almost seen only higher lows(dow bottoms). And recently on the weekly closing as on 25^th Feb, we saw that price first time closed below this dow bottom in the last two years. Which means we are structurally changed from Primary uptrend to primary downtrend. And now whatever new dow bottom will form will be a lower low(dow bottom). Second point that we want to highlight (that we couldn’t cover it last time on our new dow top) is that nifty 50 has formed a lower high(Dow top), if you see closely our last Dow top was at 18338 and the newer Dow top was at 18255.75. So it was very clear way before that we are now in a primary downtrend as per the dow theory. Now to change this Primary downtrend to Primary uptrend, we will have to wait for the price to close above the recent significant Dow top to say yes we are now again the Primary uptrend.

Now, let us resume our write-up for the investor who are already in the market and what should they do?

Remember always there is only one rule to sell. Sell when Dow tells you to sell. Because we don’t know how high the party will last for. So if you are being following Dow theory religiously and bought Nifty 50 from the very lower levels you should check breakdown of dow bottom and take decision based on the P/E ratio ranges,

If Low range: PE<20 – don’t sell

If Mid-range: PE 20-27- sell 50 % of the Total Portfolio

If High range: PE>27- sell 100% of the Total Portfolio.

So, currently our nifty 50 P/E belongs to mid-range, we should come out 50% from our Total portfolio. I know you might be thinking what for the people who only bought 50% at the time when some Dow top was broken, should they also book their 50% Nifty 50. Answer is Yes. So for the Investor who might have bought only 50% at the time when the Dow top got broken on the upside, you must have net liquid funds available of 100% in your Total portfolio. Now Investor with this liquid portfolio either having 50% or 100% should Invest in Liquid funds which can range from liquid funds to ultra-short funds to gilt funds.

Now coming to Investors who are out of the market what should they do?

Investor in this category should hold onto their nerves as they should either wait dow top to get broken on the upside or check P/E and EGR and act according. Remember only two conditions to buy:

PE and EGR both are low. If both are low then enter without even looking at Dow theory. But looking at the current scenario our EGR ratio is being very high. Although many would argue that before April 2021, NSE used to calculate earning based on standalone basis in Nifty 50. But after that they have started giving earning data based on consolidation basis. Currently NSE doesn’t provide breakdown of its earning into standalone and consolidation basis. But let’s take this data with the pinch of salt as and till nifty either provide breakdown of its earning or provide the earnings of past data in a consolidated manner.

If Dow tells you to buy. When dow top gets broken check P/E ratio and take decision accordingly.

I don’t want to make it very compliated but what I want to convey is that if you are out of the market then stay out.

If you are in the market come 50% out if you are fully invested as per the DOW THEORY. And if you are 50% invested then come out with that 50% funds and stay liquid with that 100% portfolio.

NOTE:

What about the Investor who are doing their Regular SIPs in the Index Funds?

If you are doing you SIP in index funds continue it without look at these concepts.

People will say this time is different. I don’t know whether this time is different or same. But what I know is that we have some set of rules in Investing and we are bound to follow those rules religiously without any emotional irrationality.

“And if people are yelling, ‘Swing, you bum!’ ignore them.”- Warren E. Buffett

WE Want to give all credits to Varun Malhotra Sir. The Investor/teacher who taught us this valuable theory in his own way. We in no way claim that this theory is being created by us.