The Dow Theory is still flashing a “sell” signal. Before this indicator can turn bullish again, the rally that has taken the Dow Jones Industrial Average almost straight up since its Dec. 24 low must end.
That’s why bullishly predisposed Dow Theorists should be hoping for a market pullback.
The Dow Theory is the oldest stock-market timing system in widespread use today. It was created by William Peter Hamilton, the editor of the Wall Street Journal in the first decades of the 20th Century. Its popularity is reason alone to pay close attention, since a buy signal presumably would unleash a wave of new buying in the stock market.
The Dow Theory is also worth following because its long-term track record is enviable. This has been confirmed not only by my Hulbert Financial Digest tracking of Dow Theory newsletters such as TheDowTheory.com (edited by Jack Schannep) and Dow Theory Forecasts (edited by Richard Moroney), but also by academic studies.
Though individual Dow Theorists disagree on the specifics of how to apply the Dow Theory in any particular situation, there is a broad consensus on what it takes to generate a buy signal:
1. Both the Dow Jones Industrial Average DJIA, +0.72% and the Dow Jones Transportation Average DJT, +0.93% must undergo a “significant” rally after hitting new lows — “significant” both in terms of time and magnitude. This step has been satisfied by the market’s rally from the Dec. 24 lows.
2. Both of these Dow averages must subsequently undergo a “significant” correction of the rally referred to in step #1, and in this correction either one or both of these Dow averages must hold above their previous lows (Dec. 24). We are waiting for this step.
3. Both averages must rise then rise above their highs registered at the top of the rally referred to in step #1.
One of the lesser-appreciated aspects of this three-step process is that, without a “significant” pullback (step #2), a buy signal will never occur.
How steep and long a pullback is required to count as “significant?” Unfortunately, Hamilton never precisely answered that question. One rule of thumb that some Dow Theorists have used over the decades is that, in order to be counted as significant, a pullback must last between three weeks and three months and retrace between one-third and two-thirds of the previous rally.
If that’s so, needless to say, a Dow Theory buy signal is several weeks away at the earliest.
Schannep, editor of TheDowTheory.com, has modified this traditional rule of thumb, on the grounds that while it may have been appropriate for the slower-moving markets of yesteryear, it’s not suited to today’s faster-paced markets. He imposes no minimum time limit on a pullback, and says that a 3% decline is sufficient to be significant. The stock market has yet to hurdle even this much lower bar.
In effect, Dow Theorists are agnostic about the recent rally. It might be no more than a dead-cat bounce, or it might be the beginning of a major long-term rally. We just don’t know.
That frustrates impatient traders, who fantasize about picking the exact days of the market’s tops and bottoms. Dow Theorists, in contrast, are explicitly willing to forfeit a good chunk of the market’s moves at the beginnings and endings of major trends, in return for hopefully being on the right side of the market during the middle parts of those trends.
As Schannep noted in an email: “The genius of investing is recognizing the direction of the trend — not catching the highs or the lows.”
The market’s month-long rally needs to prove itself, in other words. If and when it does, there should be plenty of time to benefit from it. In the meantime, Dow Theorists wait patiently, willing to let the market tell its story.
For more information, including descriptions of the Hulbert Sentiment Indices, go to The Hulbert Financial Digest or email mark@hulbertratings.com .