There’s a lot going on here in the stock market, as both Dow Theory and the stock market in general are flirting with some critical levels, both to the upside and the downside.
To start with, both the Dow and Transports (see charts below) are stuck in two-month trading ranges, what Dow Theorists might call a “line,” although these trading ranges are wider than the traditional definition of 5%. The indexes broke down out of those trading ranges last week – then closed back inside them the next day. While the action is at least somewhat positive – and we’ll get back to this subject in a moment – Dow Theory now views the market as bearish until the indexes close above the top of the trading range, which would be the August closing highs of 11,613 on the Dow and 4684 on the Transports.
We’ll cite Robert Rhea’s great book The Dow Theory, the first to clearly spell out the rules of Dow Theory.
In the chapter on lines, Rhea quotes William Peter Hamilton, Charles Dow’s successor at the Wall Street Journal, that once a line is broken to the downside, “it would be necessary for the last high point to be reached again before we could assume anything like a bullish indication in the average.”
So Dow Theory is pretty clear here – the market can’t be considered bullish again until the Dow and Transports close back above their August highs, unless they form bullish patterns at lower prices.
And now onto the recent low in the Dow, which is interesting for another reason. First, some background based on my own personal research. Everyone knows that the best gains for the stock market tend to follow the low point of the midterm congressional election year (think 1990, 1994, 1998, 2002 and so on), but what most traders don’t know is the importance of that midterm year low itself. From the formation of the Federal Reserve in 1913 until today, every midterm year low has supported the market for at least the next three or four years – with the only exceptions of 1930 and 2006. Both of those lows broke prematurely – the 1930 low lasted just four months, while the 2006 low of 10,667 was broken in September 2008, the day before Lehman Brothers imploded. Thus what is common between the two breakdowns is that they ushered in the two worst systemic crises of the last century, a point underscored by the market’s inability to hold up in the stronger years of the four-year electoral cycle, when presidents are running for reelection and do everything they can to boost the economy and markets.
The interesting fact of the recent low was that it closed just below the 2006 closing low of 10,667. So the market’s reaction is certainly more encouraging this time, but we’d note that the more important support level this time around is the 2010 midterm year low of 9686. That will be the critical support level for the market for the next couple of years. If it holds until 2014, the next midterm year, it would be a constructive longer-term sign for the stock market and the economy. If it breaks prematurely, it would be a sign that the financial overhang of 2008 is still very much with us and that Fed policy remains inadequate against the forces of deleveraging.
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.