Confirmed Dow Theory Sell Signal? Not So Fast…

| July 15, 2010

Dow Theory is concerned primarily with values and market behavior. It provides a useful framework for analyzing trends and forecasting likely developments moving forward. There is also something known as a classic Dow Theory sell signal, which often foretells a change in the primary (cyclical) trend of the stock market. The signal itself is relatively simple: if both the Dow Jones Industrial Average and the Dow Jones Transportation Average break below a previous low, a long-term sell signal is generated. Recall that an uptrend, in its most basic form, is simply a series of higher highs and higher lows. When that cycle is broken, the uptrend is said to have ended. The idea with regard to this signal is that a breakdown in both the main industrial average and the transports is required to confirm a long-term reversal. Some analysts question the usefulness of the signal in general, as a case could certainly be made that these two averages do not reflect the broad economy to the extent that they once did many years ago, but the signal is still watched with great interest nonetheless.

Recently, some Dow theorists have suggested that a classic Dow Theory sell signal has already been generated. Let’s take a look at the charts for ourselves and see if that is in fact true. We’ll begin with the daily chart of the Dow Jones Industrial Average.

As you can see, the downtrend from late April broke convincingly below the previous low in February, so the first half of the sell signal criteria has been met. Now let’s look at the Transportation Average.

Here is where there is debate among chart watchers. Some believe that the downtrend from May ended in early June. Consequently, the move down to a new low in late June would constitute a close below a previous low, and the classic Dow Theory sell signal would be confirmed. We would argue that the short-lived reaction from June 8 to June 21 was not in fact a new uptrend, but rather a failed attempt at one. In our view, the downtrend from May is still in progress and has yet to break below the February low, so no sell signal has been generated. Our current forecast certainly does call for an eventual long-term sell signal as defined by Dow Theory, but it has not happened yet according to our read of the charts.

If this isn’t a perfect example of how technical analysis is both science and art, we don’t know what is. Give a chart to one hundred different analysts and you are likely to receive one hundred different analyses. As always, the key to long-term success is to develop your own methods and subsequently learn to trust your own analysis.

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Category: Commentary, Market Update

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