There's something wrong in the stock market. Short-term correlations that were once reliable have been thrown into disarray. Computer-driven trading programs and massive amounts of capital are confusing even the most weathered market skippers.
As the market continues to grind higher, investors would be wise pay attention.
Dow Theory has been in use for over 100 years, and is considered to be the basis for most of technical analysis. Originally created by the father of the Dow Jones Industrial Index, Charles Dow, the theory has undergone very few changes over the last century.
One of the primary tenets of the theory is that indexes must confirm each other to forecast additional upside. Right now, Dow Theory's most critical index is showing a divergence that is incredibly bearish.
A Closer Look At Dow Theory
At its core, Dow Theory is used to clarify trends in the overall direction of the market. The theory breaks down trends into three primary parts.
1. The Primary Movement
This is the long-term trend. The Primary Movement can last from a few months to multiple years. It is the overall direction of the market over an extended period of time.
2. The Secondary Movement
This price move is in the opposite direction of the primary movement. It is a pullback in a bull market. In bear markets, it's called a reactionary rally or dead cat bounce. This movement typically has a time frame of around 10 days to several months.
Generally, The Secondary Movement retraces approximately one half of the primary movement. It's important to note that these movements tend to be more dramatic than the Primary Movement. This sharper movement often helps to shake out the weak trend followers to fuel additional upside for long-term investors.
3. The Short Swing or Minor Movement
This is Secondary Movement that does not make it to the minimum 10 days. It can last from intraday to several days and is only of interest to traders or very short-term investors.
Along with the three movements of every trend, there are three phases identified in Dow Theory.
1. The Accumulation Phase
This is when the public is confused about the direction of the trend. During the accumulation phase insiders are quietly buying shares against the general opinion of the market.
2. The Big Move
The accumulation leads to the big move which feeds on itself as more and more investors are attracted to the upside trend. Finally, the public catches on to the trend, leading to the final phase.
3. Public Participation/Excess
Once the public gets excited about a stock and everyone is talking about how great the market is performing, insiders and big money start to take profits, sending stocks into or toward a bear market.
What This Means For Today's Market
According to Dow Theory, when indexes confirm each other, the market has room for additional upside. Specifically, the theory teaches that the Dow Jones Transportation Index must confirm the trend in the Dow Jones Industrial Average.
The reason behind the confirmation makes perfect sense. The transportation sector is used to move goods from place to place, meaning greater production in booming times lifts the sector and lower volume during slow times depresses it.
If one of these averages makes a new high or low, the other one needs to confirm soon after for a Dow Theory buy/sell signal to be valid.
Right now, the transportation index is not confirming the highs in the Dow Jones Industrial Average. Yes, over the last several days, transportation stocks have bounced from the 200-day simple moving average. But they are still struggling to confirm the move in the broader indexes.
Dow Theory would call the transportation bounce the "short-term or minor" movement. This, as you just saw, is a natural part of the downtrend.
Despite the bounce, the transportation index remains over 300 points away from its highs while the DJIA keeps making new highs. This does not bode well for the future of the stock market.
Risks To Consider: Dow Theory and technical analysis, as a whole, are very inexact sciences. Never use them as a stand-alone decision making tool, but rather.
Action To Take: Reexamine your portfolio holdings with an eye to the coming bear market. It may be time to take profits on stocks you don't intend to hold for the long term.
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