Dow Theory Perspective

12/21/2009


The Dow Theory is both a system for timing the stock market and a way to put market moves in perspective.

Using the Dow Theory as a system, we believe it remains in the bearish camp. The last confirmed Dow Theory signal remains intact until proved otherwise, and the last move to significant points in both averages was the March move to new lows. Since March the market has not suffered a significant correction, so the averages are still in the process of establishing significant highs.

Using the Dow Theory as a tool for market perspective, this year’s market action can be explained three ways:

1. A continuing bear market. Under this explanation, the advance since March has been a massive bear-market rally. Typically, bear-market rallies retrace one-third to two-thirds of the preceding decline over three weeks to three months.

The Dow Industrials dropped 6,511 points from an intermediate high reached in May 2008, while the Dow Transports dropped 3,346 points from an all-time high in June 2008. With two-thirds retracements of those declines, the Industrials would trade at 10,887 and the Transports would trade at 4,378. So, the averages are still within the parameters of bear-market rally. However, the duration of the rally since March has far exceeded three months.

History provides some support for a bear-market rally that is bigger and longer than normal after a massive decline. After the 1929 crash, the Industrials rallied 48% over about five months, retracing more than 50% of the preceding decline. The bear market then resumed as the economy deteriorated and investors lost confidence in government stimulus efforts.

2. An unconfirmed bull market. After a move to new bear-market lows, there is no way to distinguish a bear-market rally from the first stage of a new bull market. To confirm a new bull market, the averages need to correct without both moving below the bear-market lows — and then rebound above the highs established in the rally from the bear-market lows.

With the Industrials up 60% since March and the Transports up 95%, a breakdown below the March lows would require a vicious correction. So, those of an optimistic persuasion may want to bet on an eventual bull-market confirmation. Of course, those pursuing this strategy should be prepared to change tactics quickly based on market action.

3. A confirmed bull market. The Industrials and Transports suffered minor pullbacks in May and June, and some viewed the rebounds from those dips as confirmation of a bull market. But neither pullback retraced even one-third of the preceding advance, and the drop in the Transports endured just one week.

Conclusion

With investor sentiment unusually bullish and the percentage of NYSE stocks trading above their 200-day moving averages near record highs, a market correction seems likely in coming months. For Dow Theorists, the ability of the averages to rebound from such a correction and reach new highs will be crucial.

In the meantime, we’re hedging our bets. Until the averages provide a valid bull-market signal, we intend to hold a portion of our equity portfolios in short-term reserves. However, partly because shares of quality companies are trading at attractive valuations, we’re comfortable holding 75% to 80% of equity portfolios in stocks.


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