Dow Theory Sell Signal?

Excerpt from Raymond James strategist Jeffrey Saut's latest essay, (published Monday November 2nd):

We arrived in San Francisco around noon last Monday. After a quick lunch with friends in Atherton, followed by another short visit with more friends in Los Altos, Cheryl and I pulled up to the hotel De Anza in San Jose (a wonderfully refurbished 1920s hotel with a great Italian restaurant named La Pastaia). After checking in I warped into the Internet only to find my email “box” slammed with questions about Dow Theory. Those questions were kindled by some alleged pundit who appeared on CNBC and declared that a Dow Theory “sell signal” had been rendered. While it is true that there are numerous practitioners of Dow Theory, over the years I have learned that many of them do not interpret the theory the way I was taught.

Charles Dow began publishing The Wall Street Journal in 1889. Considered a very astute stock market observer, Dow wrote a number of editorials wherein the concept of Dow Theory originated. Those theories were expanded on by S.A. Nelson, in collaboration with Charles Dow, in a series of WSJ editorials titled, “The ABCs of Stock Speculation.” At the end of those quips resided a footnote that read “Dow Theory.” Shortly after Dow’s death, William P. Hamilton became editor of the WSJ and wrote hundreds of similar editorials, leading to his epic book “The Stock Market Barometer.”

It was Hamilton who first wrote about the “confirmation principal” between The D-J Industrials (DJIA) and The D-J Transports (DJTA), which to me is the bedrock of Dow Theory. Following Hamilton’s death in 1930 his student, Robert Rhea, began publishing a market letter titled “Dow Theory Comment.” Rhea “called” the bottom of the stock market in July of 1932, as well as the subsequent downturn of 1937. Rhea died in 1939, leaving Dow Theory fallow until the 1940s when the great Dow Theorist George Schaefer resurrected it. To me, these folks were the “expanders” of Charles Dow’s original stock market observations. And to my knowledge the only market maven of today that really understands, and adheres to, the brilliant work of those Dow Theorist icons is Richard Russell of “Dow Theory Letters” fame.

While I could certainly respond as to why there was NO “sell signal” last Monday, Dick Russell explained the situation in his always excellent letter dated October 26, 2009 (the brackets are my inserts). To wit:

The secret of the direction of the great primary trend of the market lies in the secondary reaction and what happens AFTER a secondary reaction. A secondary reaction usually takes three weeks to three months in duration while correcting one-third to two-thirds of the previous move. Since the March low, we have yet to experience a true secondary reaction. And I'm wondering whether we could be on the edge of a secondary reaction now. Following a secondary (reaction), if BOTH Averages (Industrials and Transports) rise to new highs, the primary trend is taken to be bullish. Following the lows of a secondary reaction, there will be a rally. If (that) rally fails to take both Averages to new highs, and the Averages then turn down and break to new (reaction) lows, the primary trend is taken to be as bearish. Secondary reactions often start with one of the Averages sinking while the other Average continues to the upside.”

Well said Dick Russell. We, therefore, told our callers, “How can you have a sell-signal when we have not even experienced a downside secondary reaction since the March lows?” Indeed, you need a downside reaction, which “sets” the reaction lows, followed by a rally. If that rally fails to make a new reaction high, and subsequently breaks below the aforementioned reaction lows, then (and only then) will we have a Dow Theory “sell signal,” at least as I understand Dow Theory.

For the record, the recent closing price reaction “highs” are 10092.19 for the DJIA and 4045.11 for the DJTA. Measuring from those highs suggests a one-third “give back” would leave the DJIA at ~8910 and the DJTA at ~3412. That would be consistent with our comments in which we stated that we thought any correction would probably be contained between the 50-day moving average (DMA) and the 200-DMA. In the Dow’s case the 50-DMA is currently at ~9718 and the 200-DMA at ~8593, while the Transport’s 50-DMA resides near 3613 and the 200-DMA around 3269. Of course the markets can do anything, but I would be surprised if the Averages correct by more than one-third.

Nevertheless, we have been pretty cautious since the latter part of September, fearing that the vacuum created by the July to September melt-up might get “filled” to the downside once quarter-end window dressing is over. Initially that strategy looked good, and then it looked bad; but all said, the Averages are only marginally below where they were when we turned cautious. Yet, we are still cautious.

The call for this week: When the going gets tough the tough go on the road. That’s what we did last week and that’s what we are doing again this week, so once again these will likely be the last strategy comments of the week. Nevertheless, last week’s “wilt” left everything we follow lower except for the U.S. Dollar Index. And while the DJIA (9712.73) averted a loss in October, none of the other indices we monitor did. Indeed, the S&P 500 (SPX/1036.19) slid 3.9%, bringing its two-week retreat to 5.6%. While our sense is that we are into a secondary correction, our proprietary overbought/oversold indicator is VERY oversold and the number of S&P 500 stocks that are above their 50-DMAs has fallen from more than 90% to 33.2%. Consequently, we continue to think it is a mistake to get too bearish. Ergo, until Dow Theory “tells us” otherwise, we think the primary trend remains UP, and we continue to trade, and invest, accordingly.

Comments

[Tony Petroski:]

Makes sense.

Nov 03 10:49 AM

[Mad Hedge F...:]

bht . It all leaves me wondering, are there are snakes of a different variety lurking in the markets today? Many of the great long term plays I baled from on October 13 are suddenly a lot cheaper. The Canadian dollar (FXC) has plunged from $97.50 to $92, crude (USO) has backed off from $42 to $39, Baidu (BIDU) cratered from $440 to $355, and First Solar (FSLR) got whacked from $164 to $120. At these prices are they golden nuggets waiting to be scooped up from the ground? Or are they venomous vipers, coiled and waiting to strike an outreached hand? I vowed I would stay in cash for the rest of the year, until I lock in bonus payout. But if the best of breed investments drop much from here, I will be sorely tempted to nibble.

Nov 03 11:04 AM

[Bjarne Jensen:]

Has a first, more relevant, question been overlooked? And that is, did Dow Theory ever indicate a 'bullish' stance after the meltdown?

Nov 03 11:24 AM

[cyclingscholar:]

Good article. Don't forget that one tenet of Dow Theory is that "LINES" can substitute for secondary reactions. Do you think the May-June sideways movement (it looked like a H&S in many charts) in the dow and transports might constitute such a line?

Scary though. If there has been no secondary reaction yet, then this entire move still constitutes a rally in a bear market. So die hard Dow theorists have been 100% cash thru this entire rally. Loyalty has its price.....:)

Nov 03 12:28 PM

[ryanclarke:]

Since Buffet "bailed out" DJTA with his finaced purchase of BNI today I suspect the market might hold on for a while longer ... but it's still not going to get the wage slaves to get off the couch and stand in line at a job fair for a Taco Smell job. The Fed can only keep the market propped up for so long before gasoline pump prices get out of hand ... the market will melt down no later than the fall of 2010.

Nov 03 01:21 PM

[Socialism c...:]

Buffett has given us a sell opportunity -- the DJTA was ready to tank until this buy. Take the opportunity to get out before the plummet, with a nice bump today. One man's opinion.

Nov 03 02:31 PM

[TonyNed:]

Technically everything looks oversold and appears to be curving upward out of that condition. The DJIA just started ducking into oversold territory and the SPX looks to be at an inflection point and heading out of oversold. The banks are dramatically oversold and I believe with the price action yesterday and today a bottom has been carved out. Whether this is a temporary bottom or a solid bottom remains to be seen.

Nov 03 03:55 PM