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The decline from the intermediate high on May 12, 2010 is now putting in place the prospects for another classic secondary reaction of the Dow Industrials. According to Dow Theory, secondary reactions can range from 33% to 66% of the move upward from the previous low in the last secondary reaction.

In the chart below, you can see that the last secondary low took place at point C on February 5, 2010.

Click to enlarge:

Depending on the point you choose (using the closing price or the intraday low), the Dow reached a low at 9822.83 on February 5th. From the low, the peak in the Dow occurred on April 26th at the intraday high of 11,308.95. Based on the difference of the low and the high, the next potential downside targets are as follows:

  • 10,565.89

  • 10,318.21

  • 9822.83

According to Charles H. Dow, analysis of market action needs to take in any periods that have similar characteristics. In this case, I believe that the Dow is tracing out exactly the same pattern as had happened from January 19th to February 5th. In the points A1, B1, and C1 we can see the pattern that might materialize according to Dow’s theory.

So far, we have already traced out the pattern from A1 to B1. The turn at B1 has laid the groundwork for what we can expect might happen next. The prospect is that we fall below 10,375 and possibly turn upward somewhere around 10,200. However, because of the extreme decline that occurred on May 6th, the Dow could fall as low as point C and still reverse back to the point B1.

If the Dow falls below the blue line at point C, then we can label the market trend as bearish. In addition, all of the moves in the Dow Industrials must be confirmed by the Transportation index. The ideal scenario is that the index goes back to B1 at the very least. However, with all the recent turmoil in the markets, I would not be surprised if we got a bear market signal at point Z.

It should be noted that although I have only discussed a bunch of lines going up and down, the ideas behind the concepts are rooted in fundamentals. The very same fundamentals that formed the basis for investors like Graham, Dodd and Buffett.

Disclosure: No postions