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According to Dow Theory, the formation of a line and the stock market trading in a narrow range, typically portends a major movement in the market once the range is broken, through on the upper or lower end of the channel it has traded in. To be specific, Dow Theory indicates that a line is created when both the Dow Jones Transportation Index and the Industrial Averages Index are in a range of 5% over a period for 8 weeks or more.

In the charts below, neither index has exhibited a narrow range of 5% or less. In addition, from a strictly technical basis, it would be difficult to say that a range has not been broken on the upside in March and April of 2010 for the Dow Jones Industrial Average or the downside in July 2010 for both indexes.

However, it is challenging to ignore the general range of 10,700 to 9,750 that the Dow Industrials has traded in since late September 2009. Likewise, the Transportation index has traded in a fairly tight range since mid-May 2010.

Click charts below to enlarge

Saved for the exactitudes of Dow Theory, I believe that we’re witnessing an over-extended “line” as defined by William Peter Hamilton. Hamilton said of lines(1):

Such a narrow fluctuation, to the experienced student of the averages, may be as significant as a sharp movement in either direction.

This suggests that a range bound market is the equivalent to a stock market crash. It is hard to quantify what the extent of the crash would look like if it took place instead of trading in a range.

However, we could compare the range to the crash from October 2007 to March 2009 with the current market in terms of time. In the period from 2007 to 2009, it took approximately 17 months to flush out the weakness. The current market is bordering on 12 months of relative inaction.

If this is a correct assessment, then the price of the market must have approached some sort of alignment with the values of the market. Therefore, a rise above the upper end of the line could represent a “sudden” realization that the current market is ridiculously undervalued.

Conversely, if the weakness of the market hasn’t been wiped out of the market over the last 12 months then a slump to the downside could be devastating since a verdict indicating that we’re still overvalued would awaken investor’s worst fears about all the headlines of an economy that is getting by on dwindling government (i.e. Federal Reserve) life support.

If the pattern of a line formation is not correct then the alternative view could be that we’re witness to a classic head-and-shoulder formation in the Dow Jones Industrial Average with the head being April 2010 and the shoulders being January and August 2010.

My suspicion is that, like the pendulum on a clock, the areas in red are only reactions to the prior extremes and therefore offset the otherwise technical relevance of each extreme. Basically, the April-May extremes were counteracted by the July extremes rendering the significance of each period null and void.

The further the markets continue in this range the greater the impact it will have once that range-bound action is broken. However, the length of time that has been spent in such a range seems to indicate that we’re due for a breakdown or an explosion if the markets cross below or above the range.

This is one instance where the outcome of a 50/50 proposition could have a dramatic effect on the short-term economic decisions of our nation. Politicians vying for re-election will fight tooth-and-nail against outcomes that don’t “appear” positive.

With this in mind, it is possible that the only option is to the upside. We say this with a note of grudging acquiescence since we would rather opt for what is restoring and regenerative instead of what is expedient.

Footnote:

(1)Rhea, Robert. The Dow Theory. Barron’s (1932). page 82

Disclosure: No positions


Source: Dow Theory: The Formation of a Line