Dow Theory Trend Analysis

9/5/2011


Recent market action has provided grounds for cautious optimism. The Dow Industrials, after not confirming a mid-August breakdown to new lows in the Dow Transports, have rallied to three-week highs. The Dow Transports have rebounded within 1% of their three-week high of 4,684.44, reached Aug. 15.

The market’s ability to rally amid mixed economic news is encouraging, at least on a short-term basis. But, for Dow Theorists, the central question is whether a move above 4,684.44 in the Transports would qualify as a bull-market signal.

Three things must happen for a bull-market signal under the Dow Theory. First, both averages need to stage significant rallies. Second, on the subsequent decline, one or both averages need to hold above the previous lows. Third, both averages need to close above the highs reached in the previous rally.

The Industrials rallied more than 760 points from Aug. 10 to Aug. 15, held above the Aug. 10 close of 10,719.94 in a pullback, and then rebounded above the Aug. 15 close. So, if one views the rallies to Aug. 15 as significant, a close above 4,684.44 in the Transports would represent a bull-market signal.

Typically, after an extended drop, a significant rally retraces one-third to two-thirds of the preceding decline over three to 12 weeks. The Aug. 10-to-Aug. 15 bounce in the Industrials retraced more than one-third of the preceding decline, while the Aug. 8-to-Aug. 15 bounce in the Transports retraced less than 26%. Both bounces were very brief — three trading days on the Industrials and five on the Transports.

Insisting that moves endure at least three weeks can be problematic in today’s fast-moving markets, but the Dow Theory was not designed to trade three- and five-day swings. Considering the brief duration of the rallies to Aug. 15 — and the fact that the bounce in the Transports was well short of a one-third retracement — the weight of the evidence suggests the Aug. 15 points should not be viewed as significant.

For our money, it makes more sense to view the gain from the August lows as a single advance. From that perspective, both averages have now retraced at least one-third of the preceding declines.

Our bottom-line view

A breakdown below 10,719.94 in the Industrials and 4,221.60 in the Transports would reconfirm the bearish primary trend. If the averages suffer corrections without a breakdown to new lows in both averages, then both averages rebound above the highs reached in the current rally, the primary trend would shift to bullish. For now, as a partial hedge, our Buy List has 21.3% in Vanguard Short-Term Investment-Grade ($10.72; VFSTX), versus 26.3% for our Long-Term Buy List.


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