Category Archives: Dow Theory

Dow Theory: Non-Confirmation

On February 3, 2012, the Dow Industrial Average made a new all time high since the low of March 2009.  All that is needed in order to achieve a confirmation of the upward trend is for the Dow Jones Transportation Average to exceed the July 7, 2011 high of 5,618.25.
There is a marginal difference of 4.64% between the Dow Transports high and the current level.  We're anxiously waiting to see if this gap can be closed with conviction in a relatively short period of time.  So far, every day that the Dow Industrials makes a new high with the Dow Transports below the previous high is considered a Dow Theory non-confirmation which reinforces the bear market thesis.

Dow Theory Applied to Silver?

A reader asks:

“How do you relate Dow Theory to the Silver market?”

Our response:

Charles H. Dow was first an economist, then a commodities expert and finally a stock market analyst. Before Charles H. Dow co-founded the Wall Street Journal, he was better known for writing the “Leadville Letters” for the Providence Journal. The “Leadville Letters” reported on Colorado’s silver mining boom in 1879. After co-founding the Wall Street Journal, the lessons learned in the silver mines ofColorado were found to have application on Wall Street.

Charles Dow was keenly aware of the importance and correlation between commodity prices and stock prices. Many of Dow’s articles in the Wall Street Journal were focused on the movement of commodity prices and all costs of production that went into commodity prices from shipping to the finished product.

As an example, Dow made the following observation:

“For the past 25 years the commodity market and the stock market have moved almost exactly together. The index number representing many commodities rose from 88 in 1878 to 120 in 1881. It dropped back to 90 in 1885, rose to 95 in 1891, dropped back to 73 in 1896, and recovered to 90 in 1900. Furthermore, index numbers kept in Europe and applied to quite different commodities had almost exactly the same movement in the same time. It is not necessary to say to anyone familiar with the course of the stock market that this has been exactly the course of stocks in the same period.”

Much of Dow Theory is based on Dow’s observation of the price action of commodities and then later applied to stock prices. The application of Dow Theory to the price of silver, gold or almost any other commodity is bringing Dow’s work back to its roots. In fact, Dow’s observations in commodities and then later applied to stocks is the basis for much of the modern fundamental and technical analysis that is done today, which includes the quest to determine the “value” of a company and the uses of Fibonacci numbers.

Dow Theory is applicable to all prices that are subject to the whims of market forces. Dow Theory also accounts for manipulation and hoarding. Dow Theory attempts to account for what can reasonably be expected of price action in the not too distant future.

Sources:

  • Dow, Charles. Review and Outlook. Wall Street Journal.February 21, 1901.
  • Bishop, George W. Jr. Who Was the First American Financial Analyst? Financial Analysts Journal, Vol. 20, No. 2 (Mar.-Apr., 1964), p.26-28.
  • Bishop, George W. Jr. New England Journalist: Highlights in the Newspaper Career of Charles H. Dow. The Business History Review.Vol. 34, No. 1 (Spring, 1960) p. 77-93.
  • More on Dow Theory from NLO

Dow Theory: 1907-1910

Bull market indication (A): According to Edwards and Magee, the bull market began on April 24, 1908. The New Low Observer believes that on January 9, 1908 (C), the DJI & DJT confirmed that we're in a bull market by going above the December 6, 1907 intermediate peaks. From the point (C) of the bull signal to the respective market tops, the DJI gained 55% and DJT gained 44%.
Bear market indication (B): Edwards and Magee indicated that on May 3, 1910, the bear market signal was initiated.  However, we believe that on January 12, 1910 (D) the DJI confirmed the  DJT bearish move of falling below the September 9, 1909 low. From the point of the bear signal (D) to the respective market bottoms, the DJI lost -23% and the DJT lost -16%.

iShares Silver Trust (SLV) Update

The iShares Silver Trust (SLV) ETF has fallen in line with our assessment from May 5, 2011.  However, it is times like these that we get nervous about our ability to believe that the price action of SLV will continue on a forecast that was presented over six months ago.  Back in May, we said the following:

…we should see SLV tread water for a brief period of time before falling back to the prior low which began with the current run back in November 2008.   Dow Theory suggests that a reasonable buying opportunity would exist at [or] below line B (blue line B).
Currently, the “blue line B” is around $24.31 and rising as time passes.  In our May Dow Theory interpretation of SLV, the price fell right through line B in 2008 without any hesitation.  We’re not so certain that such action will occur this time around.  As long as SLV can hold above the Dow Theory fair value of $28.15, there is a good chance silver will be able to rebound in a meaningful fashion.  However, closing below $28.15 (again) could be a confirmation of the downtrend.    
Many precious metal enthusiasts are arguing that what happened in 2008 was an outlier event for silver and therefore is unlikely to happen this time around.  It is hard to argue against such a view. However, it is difficult to get the period from 1974 to 1976 out our mind (visual here) when gold fell 50% and gold stocks fell 66% in the middle a gold bull market.  
Below is our updated chart of SLV reflecting the most recent price action:
The Punchline: If you like the idea of investing in silver, then a buying opportunity should be at/or below the blue line B ($24.31).  However, don’t go all in, just in case the dashed blue line does materialize at $17.

 

Dow Theory: Bear Market Rally Coming to an End?

Does the end of the recent upside market action hinge on as little as 27 points? It appears that the inability of both the Dow Jones Industrial Average and Dow Jones Transportation Average to exceed the prior highs set on October 28, 2011 and October 27, 2011 (red circles), respectively, may have marked the end to the bear market rally.
The potential downside targets for both indexes are 1) the November 25th and 2) October 3rd lows, (in that order). Falling below the October low should bring a downside target of 9700 on the Dow Jones Industrial Average.  The upside targets remain in place as indicated in our October 15, 2011 article (found here).

Dow Theory: 1903-1907

Bull market indication (A):According to Edwards & Magee's book Technical Analysis of Stock Trends, the bull market began at point A. From the point of the bull signal to the respective market tops, the DJI gained 100% and DJT gained 37%. The NLO team believes that at point (C) on 12/4/1903, the DJI confirmed the 11/30/1903 DJT signal that a bull market was in progress by exceeding the late Oct 1903 peaks. From the point of the bull signal to the respective market tops, the DJI gained 126% and DJT gained 47%.
Bear market indication (B): On 4/24/1906 the DJI confirmed the 4/19/1906 DJT bearish move. The signal came when the DJT dropped below the Sept 1905 low and the DJI dropped below the December 1905/March 1906 lows. From the point of the bear signal to the respective market bottoms, the DJI lost -42% and the DJT lost -35%. The NLO team is in agreement with the Edwards and Magee as to when the bear market began.
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Dow Theory: 1900-1903

The following is the beginning of a series that examines prior bull and bear market indications according to Dow Theory since 1900.  We will include opinions and insights from the leading Dow Theory proponents and commentators from the respective periods, whenever possible.
Industrials (DJI), Transports (DJT)

Text in chart:

Bull market indication (A): On 10/22/1900, the DJI confirmed the 10/16/1900 DJT signal that a bull market was in progress.  From the point of the bull signal to the respective market tops, the DJI gained 29% and the DJT gained 60%.
Bear market indcation (B): A bear market indication was registered on April 13, 1903 when the DJT confirmed the 11/11/1902 DJI bearish move.  The critical point that set off the bearish signal was the joint delcine below the 12/12/1901 and 12/24/1901 closing prices for the DJT and DJI, respectively.  The challenge with this bear signal is the fact that the DJI was in a declining trend since June 17, 1901 while the DJT continued to register new highs at the same time not falling below the "Nipper Panic" lows of May 9, 1901.  From the point of the bear signal to the respective market bottoms, the DJI lost -30% and the DJT lost -16%.

Dow Theory: Market Behaving as Expected

On August 9, 2011, we proposed that a bottom had been established in the market. Additionally, we proposed what the upside targets were based on Dow Theory.

Our assessment of where the market bottom was (based on the August 8th low) at 10,809.85 was off by 154.55 points, or 1.42%, when the Dow Industrials reached the lower level of 10,655.30 on October 3, 2011.

The purpose of pointing out bear market rally targets is to indicate where the market is expected to go on the upside. So far there is only one upside target left from the August 9th article. All that has taken place since then has been in alignment with classical Dow Theory.

On October 15, 2011, we wrote an article titled "Dow Theory: Bullish Implications." In that article we said the following:

“The coming market volatility will provide great opportunities for traders and allow investors a chance to cash out of otherwise undesirable positions and take profits. Our expectation is that the Dow will go to the July 2011 highs before struggling at the May 2011 highs.”

Historically speaking, daily gains of 2%-3% or more in the Dow Industrials is reflective of an unhealthy market. We are repeating that the current run is a golden opportunity to shed unwanted positions. It is hoped that long-term investors are in positions that are compensating for the wait, through the reinvestment of dividend income.

We’re anxious to see whether or not the Dow Industrials and Dow Transports can exceed their respective 2011 highs. Such a breach would indicate an end to the current cyclical bear market run and the beginning of a cyclical bull market. However, the overhang of a secular bear market, marked by the October 2007 high, provides considerable resistance to even higher levels.

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Richard Russell Review: Letter 713

This review of Richard Russell’s Dow Theory Letters is dated November 9, 1977 when the Dow Jones Industrial Average was at 818.43 and the Dow Jones Transportation average was at 206.56.
  
Dow Theory
The first topic addressed by Richard Russell is Dow Theory.  On this topic, Russell says the following:
THE PICTURE: As far as I’m concerned, as far as my studies of the Dow Theory are concerned, a valid primary bear market signal was given when, on October 24 [1977], the Transportation Average confirmed the prior bearish indications of the Industrials. There are always those who cry, ‘The signal was late, it was too late!’ But no competent Dow Theorist in history ever waited for an actual bull or bear signal before taking action! For instance, we bought stocks in December, 1974 before the 1975 bull market signal, and we sold our stocks in March and April of this year well ahead of the October, 1977 bear market signal. We bought and sold on many clear indications, and the final Dow Theory signal merely confirmed what we had suspected and had acted upon.”
First, we’d like to address when a bear market signal is most likely to have occurred after the bull market signal that was confirmed in January 1975. From our perspective, the bear market was signaled on October 5, 1976 for the Transports and October 8, 1976 for the Industials when both indexes fell below the late August 1976 lows.
For whatever reason, Russell acknowledges that the call was late but doesn’t confirm how late he was.  Looking back at the October 16, 1976 issue of Dow Theory Letters  (Letter 678), in the first issue after we believe the bear market began, Russell makes no reference to the dual violation to the downside by both indexes.  Russell does allude to the Transportation Average level of 200.88 which he believed the market to be “weak” if the index fell below such a point.  On October 16, 1976, Russell said the following:
On the other hand, if the 200.88 level is broken, I would take this as a sign of unusual weakness, and I would take an even more cautious stance towards the market (which means selling more stocks and upping the bond portion of your portfolio even further.”
Naturally, there is a high level of inconsistency in suggesting that he would lighten up on his stock holdings if the Transportation Average fell below 200.88.  In the November 9, 1977 issue, Russell claimed that at the time the Transports fell below the indicated level he “sold our stocks in March and April of this year well ahead of the October, 1977 bear market signal.”
Although done in hindsight, our interpretation, almost a full year ahead of Russell’s call of a bear market, would have sheltered the investor from 3 times the loss.  This is consistent with our Dow Theory bull market indication in July 2009 and our more recent bear market call on August 2, 2011 (all NLO Dow Theory Bull Market articles) contrasted with Russell’s many bull and bear misinterpretations from March 9, 2011 (as partially outlined here).
The difference in Dow Theory Bear Market interpretations to the March 6, 1978 low:
Date
Transports decline
Industrials decline
Russell:
10/24/1977
-1.20%
-7.43%
NLO:
10/8/1976
-4.89%
-22%
Ironically, Russell says the following of those skeptical of the Dow Theory bear signal on October 24, 1977:
…others said that if it was indeed a bear signal, then probably the greatest portion of the market slide was over anyway. Two days after the bear signal, the market rallied sharply, as if in disbelief.
Since Russell’s call of a bear market was in fact long after the majority of losses were incurred, he only furthered the skepticism and misinformation of a useful tool for investors and businesses alike.  From the March 6, 1978 low to the April 27, 1981 high, the Dow Industrials increased by 37.87% while the Transportation Average increased 119.71%.  Alternatively, the Dow Industrials increased 23.17% and the Transports increased 117.55% after Russell’s indication that a bear market began on October 24, 1977.
Steps to a Dow Theory Bear Market signal:
  • July 14, 1976 Transports hit new high 231.27 but unconfirmed by Industrials
  • Sept. 21, 1976 Industrials hit new high at 1014.79 but unconfirmed by Transports
  • Oct. 8, 1976 both indexes fall below the late August lows-Bear Market begins
On page 3 of the DTL, Russell starts a Q&A with a question that has a very interesting answer:
Question: Suppose we get a rally that turns out to be a huge advance? Then what, Russell?
“Answer: We have a number of ‘fail-safes’ that work on either the bull side or the bear side of the market. The one I’m thinking about in particular is my study of the three moving averages of the Dow. At this juncture, the 13-week MA is a whopping 71 points below the 50-week MA, and we would need a crossing to get a major bull signal. Furthermore, the 4-week MA (short-term MA) is at 814, 29 points below the 13-week MA (intermediate-term) which is at 843. We need a crossing of the 4-week MA above the 13-week MA merely to get a ‘buy-alert.’ That would take time. So in the absence of a full over-sold bottom, I would say, ‘Skip any rally that may be forthcoming, or wait for the Dow’s moving averages to cross.’
There is a concern that we have regarding this section of Russell’s letter.  First, a “fail-safe” provision should address what actions to take if investments don’t work out.  Being out of stocks altogether isn’t investing nor is it working towards compounding, an overarching, albeit conflicting, theme in Russell’s work.  Therefore, Russell’s “fail-safe” observations based on a moving average requires reacting to a lagging indicator which compounds the delay in taking advantage of investment opportunities.  In fact, using such an approach causes investment activity, or lack thereof, to be made at the worst possible time.
In general, the use of moving averages for buy indications seems to be in contradiction to Dow Theory.  As pointed out earlier, moving averages are lagging indicators whereas the use of Dow Theory is supposed to act as a leading indicator.  Although Dow Theory provides bull or bear market indications not buy and sell recommendations, it can be effectively used to navigate market gyrations.  Based on the performance of the markets after Russell’s call of a bear market, it is clear that the mixing of moving averages and Dow Theory led to conflicting ideas of market direction that allowed Russell’s “Great” Depression bias to become the default reaction.
Treasuries
On page 4, Russell gives a quick blurb that had been overlooked for a long time in the mainstream media until recently.  Russell says the following:
I might also mention that if the public became wary of the banking system, there could be a major move out of bank deposits and into Treasury bills.
This has been the story of our experience in the market since 2008.  Furthermore, as the European Union struggles with their less than integrated banking system, demand for Treasuries grows.  This is in stark contrast to the belief that gold is king when there is a banking crisis.  We believe such a view is a holdover from when countries propped the price of gold with a gold standard.  The decline of gold and gold stocks in 2008 shows that there is another horse in the race for financial “safety.”
Gold & Swiss Franc
Russell points out something which seems extremely relevant to any investor in gold and that is the relationship between gold, gold stocks and the Swiss franc.  Russell says the following:
Now here’s what nobody (or let’s say very few people) know.  If I asked you “How’d you like to own Swiss francs at the early-1974 price?”  you’d probably jump at the chance.  Why would you jump?  Because the Swiss franc has been a hot item, a glamour currency.  Look at my next chart (bottom of p.5).  Note that the Swiss franc was about 31 cents in early-1974.  Gold at that time was $166 per ounce.  All right, the franc is now 45 cents or about 45% above its early-1974 price, in terms of dollars.  But gold is roughly the same price as it was in early-1974!  Now what the hell makes the Swiss franc better than gold?  The irony is that the Swiss franc is highly valued because it has such a high level of gold backing.
Nothing could be more instructive than the review of the price of gold, gold stocks and Swiss francs during what was perceived to be a gold bull market. Few gold bugs will acknowledge the amazing decline in the price of gold from early 1975 to the low of 1976.  The decline was nearly 50% of the peak price and lasted nearly two full years.  Likewise, the Barron’s Gold Average lost nearly 66% from the high achieved in 1974 to the low near mid-1976.  The Swiss franc, on the other hand, remained in the a narrow trading range or moved higher.
Russell was correct to question “…what the hell makes the Swiss franc better than gold?  Although Russell never mentions it, by pointing out the “uncharacteristic” rise of the Swiss franc at the time, we gathered that the activity of the Swiss franc implies that it is an indicator for the longer-term price of gold.  Because we’ve pointed out in many previous articles the fact that gold isn’t always the safe haven that it is fabled to be, when the next big decline in the price of gold occurs we will be watching closely the action of the Swiss franc for any indications of investment opportunities in gold stocks.  We have constructed what we believe to be a reliable indicator for the best time to buy gold stocks that are constituents of the Philadelphia Gold and Silver Stocks Index.  The action of the Swiss franc will act as a confirming indicator when the index is near a new low.
More Russell Reviews:

Dow Theory: Bullish Implications

This week the Dow Jones Industrial Average and Dow Jones Transportation Average provided indications that, according to Dow Theory, have bullish implications.  On October 14, 2011, the closing of the Industrials above 11,613.53 and the Transports above 4,684.44 suggests that the indexes will at least rise to the July highs and maybe even the April 2011 highs.
This bullish implication stands juxtapose to the bear market confirmation that was received when the Industrials and Transports simultaneously declined to new lows on October 3, 2011.  Our view is that we’re still in a cyclical bear market that cannot become a cyclical bull market until both indexes exceed the April and July highs.  To become a secular bull market, the Industrials and Transports need to go above their 2007 high.


Some would suggest that for anyone to wait until the indexes rise to the 2011 highs there would be a lot of missed investment opportunities.  However, as we’ve indicated many times in the past, we use Dow Theory signals as an allocation indicator.  During bull markets, we put more money to work and the opposite is true when there is a bear market indication.  There are few instances when we’re completely out of the market for an extended period of time based on a bear market indication, as demonstrated in our 2008 investment transactions.  Therefore, we have little concern for “missed” opportunities.


Additionally, although we got a bear market signal on August 2, 2011, which was 96 days after the April 29, 2011 peak in the Industrials, our portfolios were up for the year.  After reallocating our investment positions upon getting the bear signal, we were able to reinvest in quality companies, sometimes the same stocks, at significantly lower prices.


The coming market volatility will provide great opportunities for traders and allow investors a chance to cash out of otherwise undesirable positions and take profits.  Our expectation is that the Dow will go to the July 2011 highs before struggling at the May 2011 highs. Again, we’re still in a cyclical bear market until the Transports and Industrials exceed their respective 2011 highs.


Related article: A Lesson in Dow Theory published November 7, 2010
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Dow Theory: Bear Market Downside Target

On August 2, 2011, we received what is widely understood to be a Dow Theory bear market indication. According to Dow Theory, a bear market indication shall remain in place until counteracted by a bullish indication. The middle ground, where there is not a new bear market confirmation nor a new bull market signal, is generally considered a range or a “line.”

On August 9, 2011, we presented what we believed to be bear market rally targets according to Dow Theory. In the comment section of that same article, we revised the bear market rally targets based on the low of the Dow Industrials set on August 10, 2011.

The first bear market rally target, which seems next to impossible for the Dow Industrials to stay above, is 11,416.80. This level was only the first of five upside targets that would need to be breached for any prospect that a renewed cyclical bull market is in the works.

A confirmation of the bear market would be signaled if the Dow Industrials and Dow Transports were to fall below 10,719.94 and 4,149.94, respectively.

According to Dow Theory, we are still in a bear market and the early unconfirmed indications are that we may be headed to the 9,686.48 level.

Dow Theory: Bear Market Remains as INDPRO Surges

On Tuesday August 16th, it was reported that the current unadjusted Industrial Production Index (INDPRO) rose to 94.1525 for the month of July from the June level of 93.3075 which exceeded the March 2011 unadjusted high of 93.0943 (adj. 93.0770).  We'll have to watch closely in the coming months to determine if the INDPRO tops out with the July or August figures.
In our recent Dow Theory analysis of August 2, 2011, we indicated that we'd be surprised at an INDPRO figure that was above the March 2011 level.  As new information has come in (i.e. government revisions of the data) it appears that we have to allow for some time to pass before the stats are "finalized." We'll definitely provide updates as the revised data presents solid indications on the direction of the economy or confirmation of Dow Theory.
So far, the market still retains the Dow Theory bear market indication.  Additionally, there continues to be resistance, on the part of the Dow Jones Industrial Average, to convincingly close above the  first bear market rally target of 11,416.80.  We don't believe that it is advisable to take on new positions unless they are considered speculative in nature, which means that you're willing to accept all losses.
With a new cyclical bull market initiated when the Dow Jones Industrial Average and Dow Jones Transportation Average go above their respective highs for 2011, the missed opportunity for investment gains on new purchases between now and then are worthwhile.  When the next bull market indication is provided, our Dividend and Nasdaq 100 watch lists will point you to ideal investment candidates at reasonable values.  
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2 Years of Profitable Dow Theory Analysis

Below are the articles that take you from the beginning of a cyclical bull market indication starting on July 24, 2009 to a bear market indication on August 2, 2011.  Although it is possible to have a change from the current bear market indication to a bull market indication at a moments notice, we're willing to submit that an uninterrrupted bull market indication in a two year period within a secular bear market has yielded the intended results.  In some instances, these articles can be found on Seeking Alpha.com (found here) with added commentary from those who had questions about the concepts or ideas on the topic of Dow Theory.

 

Date Article Title Topic
8/2/2011 Dow Theory: August 2, 2011 A new bear market begins, bull market ends
6/30/2011 Waiting for Confirmation Bull market confirmation, next target Apr & May high
6/24/2011 Dow Theory: Price and Values Values, price, seeking fair profits
6/13/2011 Russell: Wrong about the Industrial Production Index Industrial Production: 1929 and today
5/4/2011 Price Decline equals Dividends Canceled Values, dividends, fair profit
4/6/2011 Richard Russell's Miscue Russell says 2007-2009 was not bear market
4/6/2011 Dow Theory: Cyclical Bull Market Confirmed cyclical bull market confirmation
2/14/2011 Dow Theory: Continuation of Bull Market Confirmed cyclical bull market confirmation
11/8/2010 Dow Theory Q&A Primary trends, confirmations, S&P in Dow Theory
11/7/2010 A Lesson In Dow Theory When to buy, sell, and wait for confirmation
11/4/2010 Dow Theory: Continuation of Bull Market Confirmed cyclical bull market confirmation
9/25/2010 Seeking Ten Percent Seeking pair profits
9/8/2010 Dow Theory: The Formation of a Line Lines
8/5/2010 Dow Theory, Stock Markets and Economic Forecasting Economic forecasting, stock markets
6/30/2010 Dow Theory Bear market non-confirmation
5/13/2010 Dow Theory Secondary reactions
4/13/2010 Dow Theory Q&A When to sell; asset allocation
4/11/2010 Dow Theory cyclical bull market confirmation
3/23/2010 Dow Theory cyclical bull market confirmation
2/23/2010 Dow Theory Q&A Manipulation; Averages discount everything
2/22/2010 Dow Theory 50% principle
1/24/2010 Dow Theory Downside targets
1/19/2010 Dow Theory on Fair Value Values and Price
1/10/2010 Dow Theory confirmation; line; 50% principle
9/24/2009 Dow Theory retest recent lows; going higher
9/2/2009 Dow Theory Double tops and Double bottoms
8/25/2009 Dow Theory Russell changes from bear to bull
8/24/2009 Dow Theory possible non-confirmation
7/24/2009 Dow Theory a new bull market begins, bear market ends
We hope you have profited from our analysis and  enjoyed our contributions to the topic of Dow Theory.
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Bear Market Rally Targets

Now that a bottom has been established, within the context of a bear market, we can calculate the bear market rally targets according to Dow Theory.  The upside targets are:
  • 11,527.87
  • 11.767.18
  • 12,073.49
  • 12,724.41
  • 12,807.51
A new bull market would be considered when the Dow Industrials and Dow Transports jointly exceed the prior highs set in May 2011, respectively.
 
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Dow Theory: Q&A

A reader has asked, “if the bear market is confirmed, do you see a possible longer term test of the lows from ’08 [2009]?”
This question is predicated on the fact that the Dow Jones Industrial Average confirms the March low as the Transports plumbed both the June and March lows. Dow Theory relies heavily on confirmations of the two key indexes and without such there is no theory.
In addition, we’ve included Robert Rhea’s use of the Industrial Production Index as an indicator to watch for. If the Industrial Production Index exceeds the prior high while the Dow Industrials fail to decline below the March low then we’ll be in a no-man’s land, which would require that the Dow Industrials and Transports exceed the May high to get a change from the current bearish condition.
From a Dow Theory perspective, the downside target relies heavily on the concept of the 50% principle. Although mistakenly attributed to E. George Schaefer by Richard Russell, the 50% principle is derived from Charles H. Dow’s “great law of action and reaction.” Dow describes the “law” in the following manner:
The market is always responsive to the great law of action and reaction. The longer the swing one way the longer it will be the other. One of the best general rules in speculation is the theory that reaction in an advance or a decline will be at least one-half of the primary movement [50% principle].
The fact that the law is working through short ranges and long ones at the same time makes it impossible to tell with certainty what any particular swing may do; but for practical purposes, it is not infrequently wise to believe that when a stock has risen 10 points, and as a result of one or two short swings [double tops] does not go above the high point, but rather recedes from it, that it will gradually work off 4 or 5 points.[1]”
In another excerpt from Dow’s work, on the topic of the 50% principle, Dow says:
It often happens that the secondary movement in a market amounts to 3/8 to ½ of the primary movement.[2]”
Again, Dow emphasis the concept of the 50% principle:
Whoever will study our averages, as given in the Journal for years past, will see how uniformly periods of advance have been followed by periods of decline, amounting in a large proportion of cases to from one-third to one-half of the rise. [3]”
Finally, George Bishop, one of the greatest authors on the topic of Charles H. Dow, concludes:
The law of action and reaction applies to both the general market and to individual stocks. This law states that the reaction to an advance or decline will approximate half the original movement.[4]”
As far as we know, the concept of applying what is commonly known as fibonacci numbers to indexes and individual stock prices was never published before Dow’s time and yet Dow is often quoted offering up such indications in the Wall Street Journal. So pervasively is the “law of action and reaction” applied to stocks that free online stock charting software allows an investor to automatically indicate the fibonacci numbers with little reference to Dow’s use of such parameters for declines or increases from a primary trend.
Based on the chart above, the 50% principle, or law of action and reaction, indicates that the next downside target at 38% is 10,417 and at 50% is 9,679. We first must reach these downside targets in order to then project the next stage of the decline.
While we believe that a fibonacci 5th wave is possible, meaning that the index could fall below the prior low of March 2009, we have seen that this type of action can be deceptive and costly to those who gamble big in the belief that the low of the 5th wave will be substantially lower than 6440. We covered this topic in an October 16, 2009 article titled “Stock Market Projections”:
The second type of market low is based on the premise that the Dow fulfills the Wave principle and falls below the upward trending line (red) to the old support level 8100 and then 6440. A true Wave move down to the old low would bring the market below 6440. However, the last time this was fulfilled, in the period from 1970 to 1974, the market only fell 8.5% below the previous low of 631.16 on the Dow Industrials in 1970. Additionally, the Industrials ran up from 631.16 in 1970 to 1051.70 in 1973, an increase of 118% of the previous peak. As more time passes I expect the index to fall to 5474 if we do manage to complete a Wave formation on the downside.”
The prior piece suggests that anything is possible between the point where we are and the point we expect to be going towards. Our personal investing experience as demonstrated by our claim of 40% gains (going long only) from January 2008 to August 2008 and closing out 2008 with +14% gains suggests that getting out of the market entirely is not exactly the solution to a bear market signal. Charles Dow has commented on this matter:
"Even in a bear market, this method of trading will usually be found safe, although the profits taken should be less because of the liability of weak spots breaking out and checking the general rise.[5]"
Finally, we do need to emphasis that our analysis of the market is subject to change as conditions change. After the very first Dow Theory bull market indication in July of 2009, we have had to continually update the status of the indexes based on all significant and indications. Since that time, we’ve issued more than ten confirmations that the trend was bullish.
Likewise, we will have to revisit our August 2nd call with relevant updates that support or change our view. For now, the market bias is definitely bearish and would require both the Dow Industrials and Dow Transports to exceed the previous May 2011 highs to change our current view.
Citations:
[1] Dow, Charles H. Wall Street Journal. October 19, 1900.
[1] Bishop, George. Charles H. Dow and the Dow Theory. Appleton-Century-Crofts. New York. 1960. page 119.

[1] Sether, Laura. Dow Theory Unplugged. W&A Publishing. 2009. page 112.
[2] Dow, Charles H. Wall Street Journal. January 22, 1901.
[2] Bishop, George. Charles H. Dow and the Dow Theory. Appleton-Century-Crofts. New York. 1960. page 120.
[2] Sether, Laura. Dow Theory Unplugged. W&A Publishing. 2009. page 117.
[3] Dow, Charles H. Wall Street Journal. January 30, 1901

[3] Bishop, George. Charles H. Dow and the Dow Theory. Appleton-Century-Crofts. New York. 1960. page 120.
[3] Sether, Laura. Dow Theory Unplugged. W&A Publishing. 2009. page 199.
[4] Bishop, George. Charles H. Dow and the Dow Theory. Appleton-Century-Crofts. New York. 1960. page 231.
[5] Schultz, Harry D. A Treasury of Wall Street Wisdom. Investors' Press. (New Jersey, 1966). p. 12. Additional commentary here.

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