An Introduction to the Short Term Momentum Dow Jones Industrials Model

Includes: AA, CAT, CVX, DD, HD, IBM, JPM, KO
by: The Other Street

I would like to introduce you to our proprietary technical tool, the Dow Jones Industrials Model. I will be sharing the results with you on a regular basis, so you might as well know how it works.

Most of the time, when we venture about the market's future trend, we look at the index as a whole, whichever index it may be. We may use several technical filters, say five. That's five observations in statistical terms. The problem is that the standard deviation of each individual stock's relative performance is so great that it is, statistically speaking, a fairly useless execise.

I use three observations: a) the conventional price action, to determine support and resistance and b) the exponential 3 and 9-day moving average convergence, "MAC," and c) the divergence with a modified RSI, "AA," to determine momentum. This last one is proprietary. However, I then look at each individual component. I do this for specific portfolios, but they have to be of a size small enough to be practical. I use the Dow 30 for that reason. This makes for 90 observations, which I then aggregate.

Once the price range is set, the question is what are the odds that a stock trends to support or resistance. This is derived from MAC and AA. I rank these observation into four categories each: 1 for bottom, 2 for uptrend, 3 for top and 4 for downtrend. I then ascribe probabilities to each categories and a weight to MAC and AA.

The momentum summary are the means for MAC and AA. As of the close of Monday 27th, they were respectively 1.77 and 2.30 (the means were 1.0 and 2.5). This suggested that the DOW was in a bottoming phase, with a potential pick up in momentum.

The price summary was that, for a close of 12044, support was at 11871 and resistance at 12228. the combination of price and momentum called for a target of 12048, slightly in oversold territory, with stock closer to support than to resistance. This is called the OB/OS ratio - it was at 0.45.

Here is how I use the model. One, of course, is to figure out whether the market is likely to go down or up. Two and more importantly, to determine whether the likely trading range is broken. For that, I will simply number the stocks that actually break their trend. If a third do, the odds are the trend wil be broken.

As of 10:57 this Tuesday, we are at Dow 12154, trotting towards resistance. The stocks that are testing their short term resistance are Chevron (NYSE:CVX), ($100.2), Coca-Cola (NYSE:KO), ($66.0) and Alcoa (NYSE:AA), ($15.4). Those that have broken it are HD ($36.05), IBM ($169.67), MCD ($83.44), CAT ($103.34) and DD ($52.50).

The only one testing support is JPMorgan Chase (NYSE:JPM), ($39.3).

This does not necesssarily mean that you should buy or sell these stocks. First of all, see the disclaimer at the bottom ... Second, these are technical observations. If fundamentals can lead to the wrong choice, technicals certainly can too!

So what do I do with this. Well, it is another data point. Certainly, I was looking at DD - I feel better in this configuration. Also, if the trend looks like it will broken, in this case on the upside, it makes me think about putting some more risk on the table.

When do I find it most useful - again, with all the precautions that go with this statement? At tops and bottoms. This is when we usually don't really know where will the trend stops. Certainly, this is the case now. Like everybody else, I was tempted to write gloomy articles, if only because of the headline noise. Last night, I was not particularly ready to tweak my cautiousness. Clearly, this morning action is encouraging - now we need to look for fundamental confirmation. I can still see the tunnel, I can't see the light yet.

Going back to my previous post of June 20th, one thing can be said - the 25% retracement from the July 2010 S&P lows has been successfully tested at 1277. Resistance is now 1300. Form yesterday's close, that's 1.56%. Close enough to the 1.52% the model suggested.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in DD, AA over the next 72 hours.