The State Of The Dow Theory

6/4/2012


When both the Dow Industrials and Dow Transports are reaching significant highs, the market's primary trend is bullish, according to the Dow Theory. When both are reaching significant lows, the primary trend is bearish.

But when the averages are trading sideways in zigzag fashion, identifying which highs or lows are significant can become difficult. In a bull market, significant points mark the end of significant corrections, which typically retrace one-third to two-thirds of the preceding advance over three to 12 weeks.

From lows reached Oct. 3, the Industrials and Transports rallied sharply to reach respective late-October highs of 12,231.11 and 5,025.09, then retraced at least one-half of those rallies in pullbacks to reach 11,231.78 and 4,533.44 on Nov. 25.

In December, when both averages rebounded from those lows to surpass the late-October highs, a bull-market signal confirmed the Dow Theory was in the bullish camp. The Industrials ultimately reached 13,279.32 on May 1, but the Transports never advanced beyond their Feb. 3 close of 5,368.93.

From late December to May 1, the Industrials did not suffer a significant correction. The closest the Industrials came was the April 2-to-April 10 pullback, a five-day drop that retraced 27% of the Nov. 25-to-April 2 advance.

The Transports suffered a significant pullback from Feb. 3 to March 6 before rebounding to 5,360.04 on March 19, then slumped to 5,088.13 on April 10 before a bounce to 5,334.52 on May 2.

Some argue the Dow Theory turned bearish in mid-May, when the Industrials and Transports closed below the levels reached on April 10. We see three problems with this line of reasoning:

• First, it means the April 2-to-April 10 decline in the Industrials must be viewed as significant, even though it fell short of a typical secondary correction based on both duration and extent.

• Second, it means that the April 10 close in the Transports must be viewed as a significant low, even though this point was higher than the March 6 close and followed a rally that failed to surpass the Feb. 3 close.

• Third, it means the most useful part of the Dow Theory — the idea that no price movement is worthy of consideration unless confirmed by both averages — must be overlooked. While one could argue the Feb. 3-to-March 6 decline in the Transports was significant, that correction was not confirmed by the Industrials. And even if one views the April 2-to-April 10 drop in the Industrials as significant, the Transports did not suffer a corresponding decline.

Conclusion

Especially in today's fast-moving market, insisting that all significant declines meet the parameters of a typical secondary correction can lead to tardy bear-market signals. But unless one views a five-day decline in the Industrials as significant and somehow contrives the April low in Transports as a significant point, it seems a stretch to call the move below the April 10 closes a bear-market signal.

If the averages rebound without closing above 13,279.32 and 5,368.93, then close below the lows established in the current correction, the Dow Theory will turn bearish. Moves above both those points would reconfirm the bullish primary trend. In the meantime, we intend to watch the averages while holding 13% to 16% of stock portfolios in a short-term bond fund.


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