Wednesday, April 9, 2014

The Stock Market and Dow Theory

By: Tim_Wood

I have recently received a number of e-mails, phone calls and texts asking if we have recently seen a “Dow Theory Buy Signal.”  As I understand it, this question was prompted as a result of the Industrials and the Transports having moved to new intraday highs last week.  I want to explain each and every issue with this alleged “Dow Theory Buy Signal.” Then, I will walk you through the Dow Theory events that have followed in the wake of the 2009 low and where we are now in accordance with Dow Theory. 

First and foremost, there is no such thing as a Dow Theory “buy” or “sell” signal.   Such terminology was never used in any of the writings by our Dow Theory Founding Fathers. Fact is, the Dow Theory Founding Fathers did not use a move above or below a secondary high or low point as a buy or sell signal.  This is a myth.   Rather, they established positions on weakness at what they termed “buy spots” and moves above previous highs were used as confirmation, not as a “buy signals.”  There is no question, the Dow Theory Founding Fathers clearly advocated establishing positions upon “dullness on declines after secondary reactions.”   Here is a direct quote on what they termed “buy spots.”  “Our theory of buying in a bull market, which all readers should know by this time, is to take on stock when, after a reaction, trading becomes dull on further recessions.”    The notion of Dow Theory “buy and sell signals” after a move above or below a previous low is simply wrong and is a product that has evolved from a lack of understanding and misapplication of Dow theory over the years. 

The next issue with an alleged “buy signal” having occurred last week, is that the Industrials moved to a new high only on an intraday basis.  The Dow Theory Founding Fathers used the closing price only.  In fact, in those days, only the close was recorded.  So here too, to call an intraday movement above a previous intraday high an alleged “buy signal,” is invalid.  Per the Dow Theory Founding Fathers, it is clearly the close that counts. 

According to Dow Theory, once a primary trend change occurs, that trend is considered to be “in force” until it is “authoritatively reversed.”   According to Dow theory, an authoritative reversal requires a joint move below or above a previous secondary high or low point, depending on whether it is a bullish or bearish primary trend that is being reversed.   So, even if you were to erroneously call a move above a previous secondary high point on an intraday basis a “buy signal,” since we have not seen an “authoritative reversal” of the previously established primary bullish trend change, an intraday move above a previous high could not trigger another alleged “buy signal” if the existing “buy signal” was never reversed.   Bottom line, we did not have a Dow Theory “buy signal” last week.

With this behind us, I want to walk you through the Dow theory events since the 2009 low in order to show you where we are in accordance with Dow theory and how we got here. 
Following the 2009 low, both averages closed above their previous secondary high points on July 23, 2009.  As a result, a Dow Theory Bullish Trend Change occurred.  Not a “buy signal,” but a bullish primary trend change.  This trend change did not suggest that we were in a secular bull market.  For the record, there were bullish primary trend changes within the 1966 to 1974 secular bear market, which also saw new highs, but was ultimately followed by new lows into the 1974 secular bear market.   Nonetheless, following the July 23, 2009 bullish trend change it remained intact and the market continued higher into the 2011 high.  For the Industrials that closing high occurred on April 29, 2011 and for the Transports the high close was seen on July 7, 2011.  As a result, this left a Dow Theory non-confirmation in place, which I have noted on the Dow Theory chart below. 

Following that Dow Theory non-confirmation, the averages jointly closed below their previous secondary low points on August 4, 2011, which triggered a Dow Theory Bearish Primary Trend Change.   When this occurred, I did acknowledge that it was a bonafide bearish trend change, but I also stated in articles and interviews that “ Not all Dow Theory Primary Trend Changes were created equally.”  I further stated that I had to “discount this primary trend change” and that in spite of my longer-term bearish views I actually looked for the market to move above the previous highs once the next intermediate-term cycle and secondary low point was seen.  This was documented in interviews and articles on various websites and in great detail to my subscribers in the monthly research letter.

In spite of my longer-term bearish views, I was able to make that call simply as a result of my statistical based research and the fact that none of the DNA Markers associated with major long term tops were seen in conjunction with that Dow Theory bearish trend change.        Point being, while the statical based DNA Markers can be used to tell us when we have seen a major top, their absence tells us when we have not.   Just as their absence and the statistics suggested, the anticipated low was seen in October and higher prices followed with the Industrials moving to a new recovery high in February 2012.   However, at that point the Transports had not confirmed the continued advance seen by the Industrials.  As a result, since the previously establish bearish trend change had not been “authoritatively reversed” by a joint close above the previous secondary high points, the previously established bearish trend change officially remained “in force.”   Finally, as the missing DNA Markers suggested, higher prices prevailed and on January 18, 2013 both averages closed above their previous secondary high points.  As a result, the August 4, 2011 bearish primary trend change was “authoritatively reversed” with a bullish primary trend change.   From that point both averages moved higher throughout 2013 and into their last joint closing high, which occurred on December 31, 2013 at 16,576.66 on the Industrials and at 7,400.57 on the Transports.   This joint secondary high point was followed by further strength on behalf of the Transports into their January 23, 2014 high at 7,569.89, at which point, both averages moved down into their early February lows.   From those lows the Transports have yielded a higher close, which occurred on April 2, 2014 at 7,695.51.  But, the high close for the Industrials in association with the advance out of the February low occurred on April 2, 2014, which occurred at 16,573.00, falling short of the December 31, 2013 close.  As a result, rather than a totally erroneous Dow Theory “Buy Signal” having occurred in association with the advance last week, fact is, we actually have an upside Dow Theory non-confirmation in place.   Robert Rhea wrote, “a wise man lets the market alone when the averages disagree.”    Now, this non-confirmation could be mended, but until it is, it stands.   Also, the possibility exists that this could prove to be just another correction that is followed by higher prices.  This all depends on whether we see the statistical based DNA Markers and the associated structural setup solidified. 
This now all leads me to the problem that I have found with Dow Theory.  Not that it is complicated.  The real problem is the absence of study from the appropriate sources.   Until one has sat in front of a computer with charts and gone through the original writings by Charles H. Dow, William Peter Hamilton and more specifically, Robert Rhea, there is no way for one to understand Dow Theory, PERIOD!   On the surface, Dow theory appears simple and it is.  But, when people see the general concept, they assume they understand it and that they can appropriately apply the principles.   I have found that 99.9% of all Dow theory articles are WRONG.  I also hear all the reasons why Dow Theory did not work or that it no longer works.  Not true.  The Dow theory works perfectly fine just as it has for the last 117 years.  The problem is simply its misapplication and the spreading of bad information.  Richard Russell helped me obtain ALL of the original writings from Robert Rhea years ago and I found that it was not until I went through that material closely that I truly understood Dow Theory.  I realize that this is a strong statement, but unless a Dow theory article comes from Richard Russell or thanks to Mr. Russell, myself, I would not trust the article and the current misread of a so-called “Buy Signal,” with what is actually a Dow Theory non-confirmation, is a perfect example of why.  

Now as to the current market, I continue watching for my statistical based DNA Markers and the necessary structural developments to solidify a top.  As I have maintained all along, until such time, the advance will continue.   Cyclically speaking, which has absolutely nothing to do with Dow theory, the advance out of the 2009 low is now the longest 4-year cycle advance in stock market history.   I maintain that the rally out of the 2009 low has not been a secular bull market and that it is apt to ultimately result in a manufactured financial holocaust.  Once the proper statistical based DNA Markers and structural setup are in place, I truly find the potential downside fallout terrifying.  There is no doubt in my mind that this advance has NOT been a secular bull market and that the decline out of this very extended 4-year cycle top has the potential to dwarf the destruction seen in association with the decline into the 2009 4-year cycle low.    If you want to know more about the statistical based research in which I base this opinion or the specifics on the DNA Markers and the structural setup that will eventually cap this advance, that research is available at cyclesman.com through the subscription based research letters.

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