CHAPEL HILL, N.C. (MarketWatch) — According to the Dow Theory, the oldest stock market timing system that remains in widespread use, the bull market is still alive.
But only barely.
A “sell” signal could be generated as early as Friday (March 2), provided there’s another down day like those from Tuesday through Thursday. The Dow Jones Industrial Average slid 1.7% Thursday, accelerating from Wednesday’s 1.5% decline and Tuesday’s 1.2% decrease. Investors are worried that faster inflation might prompt the Federal Reserve to raise interest rates more than had been expected.
The Dow Theory, for those who don’t know its history, was created a century ago by William Peter Hamilton, then the editor of the Wall Street Journal. He introduced his theory in stages over several decades in editorials in his newspaper, leaving to generations of followers the task of devising specific rules for what triggers a “sell” signal.
Though not all of the Dow Theorists I monitor agree on every detail, there is broad agreement that a bear market signal won’t be triggered until the market jumps over three successive hurdles:
1. Both the Dow Jones Industrial Average DJIA, -1.68% and the Dow Jones Transportation Average DJT, -0.49% must undergo a significant decline after hitting new highs — “significant” both in terms of time and magnitude. This step was hit in the market’s greater-than-10% correction from the late January highs to the early February lows.
2. In their subsequent significant rally following the decline referred to in step one, either one or both of those Dow averages must fail to surpass their highs. This step was satisfied in the market’s rally attempt through its Feb. 26 recovery high which — though it was 8% higher than its early February low — failed to take either Dow average above its January highs.
3. Both averages must then fall below their lows registered at the bottom of the decline referred to in step one. The levels to watch, therefore, are 23,860.46 points in the case of the Dow Industrials and 10,136.61 for the Dow Transports.
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Notice that we are uncomfortably close to those step-three levels getting hit, thereby triggering a Dow Theory “sell” signal.
Dow Theorists don’t like to jump the gun trying to guess whether a third step will be satisfied or if, in contrast, the market steps back from the cliff and rises back to new all-time highs. They instead adopt a “wait and see” attitude, letting the stock market tell its story in its own time.
And one of the core principles of the Dow Theory is that, until that story is told, the previous signal is assumed to remain in force. And since the last Dow theory signal was a “buy” signal, Dow Theorists, at least for the moment, remain bullish.
Notice carefully that the Dow Theory will not catch the exact top of the bull market. “Sell” signals will always occur several percentage points below that top. This is intentional, since Hamilton believed that those several percentage points are an acceptable price to pay in order to avoid getting whipsawed in and out of the market every time there is extraordinary volatility.
Even those who are not followers of the Dow Theory can recognize the value of that trade-off. As Jack Schannep, editor of TheDowTheory.com, one of the country’s leading Dow Theorists, put it to me in an email: “The genius of investing is recognizing the direction of the trend — not catching the highs or the lows.”
The bottom line? For now, sit tight. But a Dow Theory “sell” signal could happen any day.
For more information, including descriptions of the Hulbert Sentiment Indices, go to The Hulbert Financial Digest or email mark@hulbertratings.com.