Charles Dow's Original Editorials and Their Relevance Today

Archive for August, 2011

Dow Theory Gets Tested

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Now looks like a good time to revisit the recent apparent Dow Theory sell signal.

With the Dow approaching its breakdown point of 11,865, the bulls’ resolve could get tested, particularly with a seasonally weak six weeks ahead of us. But a strong move above that level could be the first sign that the bears are losing control.

As we noted earlier this month, major bear markets are rare if the NYSE advance-decline line tops out at the same time as the market, as happened earlier this summer. How rare? We can find only two bear markets – 20-25% declines in 1946 and 1977 – where the NYSE A-D line didn’t top out before the market, in data going back to 1926. (Thanks to Tom McClellan for help researching that.)

Sentiment is turning market-positive here, with Investors Intelligence bears on the rise and commercial future traders long the big S&P contract.

But with September and October still ahead, caution would be wise for now.

Paul Shread is a Chartered Market Technician and co-author of the book “Dow Theory Unplugged: Charles Dow’s Original Editorials and Their Relevance Today” from W&A Publishing.

Dow Theory Turns Wobbly

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Plenty of smart people are calling the recent action in the Industrials and Transports a Dow Theory sell signal, but we’ll hold off for two reasons: last month’s new bull market highs in both the Transports and the NYSE advance-decline line (see charts below).

Dow Transports

NYSE advance-decline line

I look for persistent new trends in both the Industrials and Transports before calling a major trend change, and last month’s new bull market high in the Transports means the index still needs a four-week rally followed by a new closing low to confirm the Dow’s bear signal. I look for 18 trading days for an intermediate-term move, so an 18-day rally followed by a new closing low would do it. Some who see this as a Dow Theory sell signal are calling the top in the Transports a “line,” or trading range, which the index broke down out of. That view has some historical legitimacy, although it’s a pattern the market hasn’t seen in recent decades.

Still, it’s hard to see this becoming a major bear market when most NYSE stocks continued to gain right into the top; that suggests that there may be enough liquidity to limit the decline. As Paul Desmond of Lowry Research noted in a 2006 paper, market internals tend to erode before the top if a major bear market is going to occur.

That said, the market is quite ugly here, but all the pieces aren’t quite in place yet to declare it a bear market.

Paul Shread is a Chartered Market Technician (CMT) and co-author of the book “Dow Theory Unplugged: Charles Dow’s Original Editorials and Their Relevance Today” from W&A Publishing.