Market Direction and Stock Trends

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What the oldest market-timing system is telling stock investors
By Mark Hulbert

* July 11, 2016

Despite equity indices near record highs, the Dow Theory remains bearish

CHAPEL HILL, N.C. (MarketWatch) — The bear market in stocks remains alive and well, according to the oldest stock-market-timing system that remains in widespread use today.

I’m referring to the famous Dow Theory, which was created a century ago by William Peter Hamilton, who at the time was editor of the Wall Street Journal.

It’s not that Dow Theorists are unimpressed by the strength of the stock market’s recovery from its post-Brexit plunge, which has taken many averages to new all-time highs. But a Dow Theory “buy” signal requires the market to first undergo a series of backings and fillings, and stocks’ nearly uninterrupted rally over the past couple of weeks doesn’t satisfy.

To be sure, not all Dow Theorists agree on the specific hurdles the market must jump over to generate a buy signal. Their disagreement is inevitable, since Hamilton never codified his market-timing system into a comprehensive set of rules that could be mechanically applied to every possible situation. He instead introduced it in dribs and drabs over three decades of Wall Street Journal editorials.

Nonetheless, there is general agreement about the three steps needed to generate a buy signal:

1. Both the Dow Jones Industrial Average DJIA, +0.65% and the Dow Jones Transportation Average DJT, +0.33% must undergo a significant rally after declining — significant both in terms of time and magnitude.

2. In their subsequent significant correction following the market’s rally referred to in step No. 1, either one or both of those Dow averages must remain above the initial lows.

3. Both averages must then rise above their highs registered at the top of the rally referred to in step No. 1.

Notice that the market’s rally over the past few weeks satisfies just the first of those three steps.

Hamilton (along with his colleague Charles Dow, the founder of Dow Jones) used a beach analogy to explain the rules: To determine if the tide is coming in, you need to compare at least two successive waves. The answer is “yes” only if the second wave goes further up the beach than the first, and the between-wave trough isn’t as deep as the previous one.

The bottom line about the current market, using that analogy: That was a powerful wave that just washed up on the beach. To prove that it wasn’t a rogue wave, however, the ocean must produce a subsequent wave that’s even more powerful.

And another principle of the Dow Theory is that, until and unless the primary trend is determined to have changed, the previous signal remains in effect.

What if the stock market continues higher and higher without interruption? Some Dow Theorists I monitor have a fail-safe level that is triggered in such an event, though the market would have to rally a lot further in order for it to be triggered.

One such Dow Theorist is Jack Schannep, editor of TheDowTheory.com. He says that if the Dow Jones Transportation Average surpasses its April high, then at least his version of the Dow Theory would generate a buy signal. Note that this would require a 5% rally from that average’s current level.

http://www.marketwatch.com/story/what-the-oldest-market-timing-system-is-telling-stock-investors-2016-07-11

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