Please Note: Blog posts are not selected, edited or screened by Seeking Alpha editors.

Dow Theory And The Bull Market's Second (Ongoing) Test

|Includes: SPDR Dow Jones Industrial Average ETF (DIA), IYT

In articles I and II I outlined the principles of Dow theory and applied it to the market's action since, in my analysis, a Bull Market was signaled by action of the Industrials (NYSEARCA:DIA) and Transportation(BATS:IYT) averages in the spring of 2009. Dow Theory tells the investor to assume the bull market is ongoing until the following happens:

  • a secondary reaction of meaningful extent and duration occurs;
  • prices recover briefly and attempt to reach new highs;
  • the attempt fails and new local lows are set in both averages.

We used these principles in arguing that the market gyrations in the summer of 2010 did not constitute a bear market signal.

What about the market action in spring through early fall of 2011? In my opinion, a bear market was signaled and then almost immediately reversed. Why do I say this? First, look at the Industrials over this period.

Notice the selloff from late April to late June. It clearly met time and extent requirements. The rally into July failed to set a new high and the summer collapse took prices to new lows. Thus the Industrials suggested a bear market had started. What about the Transports?

The Transport selloff was a bit shakier in terms of extent; and prices, in fact, did recover to new highs in July while the DIA did not. I gave the DIA the benefit of the doubt and when prices collapsed to new IYT lows in July that average had 'confirmed' that a bear market was in progress. It sure felt like one! The numerous sharp selloffs into the fall seemed to fit the scenario as well.

But what happened in the next few months? The surge in October was clearly a secondary reaction (rally) against the now prevailing bear market, and when prices marked time in November and December before going to new local highs in both averages just before Christmas, a new bull market had again been signaled. What do we make of this?

Keep in mind the Dow Theory is designed to keep us on the side of a major long term trend. Bear markets do not last for 5 weeks; bull markets do not last 5 weeks..They are long term events related to economic and business developments. Thus, with the advantage of hindsight, it is better to just rewrite the entire selloff in the summer of 2011 as one single secondary reaction against the bull market that began in the Spring of 2009.

Where does this bring us? The Industrials have, since, rallied to a new local high in February of 2012. So the Industrials have confirmed the ongoing bull market, now over 3 years old. But, notice the transports have not rallied above their July 2011 high of 100. Thus, the transports have not confirmed the bull market....yet. Under dow theory principles, we should assume the bull market is still in progress; but there is now some doubt.

In order to confirm the Bull market the transports must surpass last summer's highs! We've been waiting a LONG time. But in dow theory such periods do, indeed occur, and they call for patience on the part of investors.

I might add that some analysts believe a bear market was signaled this past May when the Industrials touched a high for the year, IYT did not, and then both indexes sold off. In my opinion these gyrations in SPY and IYT were not substantive enough, or lengthy enough, to be classified as secondary reactions. So I disagree with this view, although the continued punkiness of the Transportation average is a matter of concern to long term investors.

Disclosure: I am long SPY, DIA.