Big Bounce Raises Questions



Did the market bottom on March 9, when the Dow Industrials closed at 6,547.05 and the Dow Transports closed at 2,146.89? Only time can answer that question with certainty, but the Dow Theory provides some valuable guidelines for investors:

The primary trend is presumed intact until proved otherwise, and the last significant development under the Dow Theory was the move to fresh multiyear lows in early March.

For a return to the bullish camp, three things must happen. First, both averages need to stage significant rallies. Second, both need to retreat, with at least one holding above the March 9 closing lows. Third, both averages need to rally above the closing highs reached in the rallies from March 9.

In general, significant rallies retrace one-third to two-thirds of the preceding decline over three weeks to three months. With the rallies since March 9 less than two weeks in duration, labeling them as significant seems premature.

Determining whether the initial rallies from the lows qualify as significant is often the hardest part of calling a bull-market signal, and that task could be especially challenging this time because of the huge declines in the second half of 2008.

As we see things, the last significant highs in the averages were reached May 2 in the Industrials at 13,058.20 and June 5 in the Transports at 5,492.95. Based on the declines from those levels, one-third to two-thirds retracements would put the Industrials at 8,700 to 11,000 and the Transports at 3,250 to 4,400.

Alternatively, if one views the respective January highs of 9,034.69 and 3,717.26 as significant, one-third to two-thirds retracements would put the Industrials at 7,375 to 8,200 and the Transports at 2,670 to 3,200. The Industrials have already reached the threshold, and the Transports are close.

The rallies from November to January did not quite qualify as significant, suggesting we should view the drops from May and June to January as uninterrupted declines. But the Industrials would need to advance more than 30% from their March 9 close to reach 8,700, while the Transports would need to advance about 50% to reach 3,250. Insisting on such big advances could lead to a tardy bull-market signal.

History suggests it is a mistake to take the one-third to two-thirds retracement guideline too literally, that common sense is the best guideline in periods of ambiguity. So, we intend to place considerable importance on the duration of the current rally and the action of the broader market. Also, there is little to be gained by prejudging the significance of the rally since March 9. For now, subscribers should watch the averages and hold 30% to 40% of equity portfolios in a short-term bond fund.

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