Market Will Settle All Dow Theory Arguments

9/27/2010


One self-described follower of the Dow Theory argues the primary trend was confirmed as bullish on Sept. 20, when the Dow Industrials and S&P 500 Index closed above their August highs. Others argue a close in the Dow Transports above their August high of 4,516.35 would confirm the Industrials and put the Dow Theory in the bullish camp. We disagree with both arguments, for two reasons:

First, a strict focus on the Industrials and Transports, which represent different parts of the economy and have a long history of working well in concert, is central to the Dow Theory. Because the Industrials and Transports often go in different directions in the short run, a move to new highs or new lows in both is less likely to be a false signal. In contrast, the Industrials and S&P 500 Index are highly correlated.

Second, the August highs do not represent significant points. William Hamilton, who expanded on the editorials of Charles Dow to formulate the Dow Theory, was somewhat ambiguous on the identification of significant highs and lows. But Hamilton and others provided basic guidelines that can help put market moves in perspective, and it is hard to see the August highs as significant under any reasonable Dow Theory interpretation of this year’s market action:

In late April and early May, the Industrials and Transports reached significant closing highs of 11,205.03 and 4,806.01. These points, the highest levels in more than 18 months and more than 70% above the March 2009 lows, are clearly significant under the Dow Theory.

In May and early June the averages suffered indisputably significant corrections, with the Industrials dropping 12% to the June 7 close of 9,816.49 and the Transports dropping 16% to the June 7 close of 4,037.98.

From the June 7 lows, the Industrials rebounded 6.5% to reach 10,450.64 on June 18, while the Transports bounced 11% to reach 4,467.25 on June 15. Some say these rebounds were too short-lived to qualify as significant, while others argue that even a 3% rebound after a meaningful correction is enough to label the correction’s low as significant.

From the mid-June highs, the averages retreated below the June 7 closing lows. We viewed this breakdown as a bear-market signal, while those who did not think the June rebound was significant viewed this decline as a continuation of the correction from the April and May highs.

While an argument can be made for viewing the entire decline from this year’s highs to the July lows as a single correction, this interpretation would not qualify the August highs as significant. A rebound above 11,205.03 and 4,806.01 would be significant because it would reconfirm the trend as bullish, but the August highs have no significance if the primary trend is already viewed as bullish.

Indeed, the only way the August highs can be viewed as significant is to argue that a bear market ended in July and that the July-to-August bounce was the first move higher in a new bull market. That seems a stretch, considering that the April-to-July decline in the Industrials was less than 14%.

Conclusion

The Dow Theory is not infallible, and even Hamilton warned that “the road to ruin lies in dogmatizing on charts, systems, and generalizations.” But our work suggests the significant points to watch are 11,205.03 and 4,806.01 on the upside and 9,686.48 and 3,906.23 on the downside. For now, our plan is to watch the averages while holding 25% to 30% of our equity portfolios in a short-term bond fund.


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