Potential Dow Theory Sell Signal

| August 26, 2010

In July, we analyzed the development of an unconfirmed Dow Theory sell signal that accompanied the violent correction following the long-term peak in late April. In general, 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 (DJIA) and the Dow Jones Transportation Average (DJTA) 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 DJIA and the DJTA 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.

The signal was unconfirmed in July because only the DJIA closed below the February low. The DJTA held above its comparable support level until the next rally began. However, the uptrends from early July failed to move up to new long-term highs before breaking down in early August, setting us up for another potential sell signal during the next several weeks.

If the DJIA subsequently closes below the July low of 9,686 and the DJTA also closes below its comparable low of 3,906, a classic Dow Theory sell signal would be generated, indicating a confirmed primary trend reversal. Granted, at that point, the massive S&P 500 index topping formation will have broken down as well, so this potential sell signal would serve to confirm the new cyclical downtrend in the broad stock market.

Category: Commentary, Market Update

Comments are closed.