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Why Dow Theory Still Works

Published on May 22, 2015 by in Dow Theory, Eating Cat
Dow Theory

There has been an increase in news stories about Dow Theory lately. Most of the discussion has been focused on the divergence between the transports (DJTA) and the industrials (DJIA). As you know I’ve added to the news flow by highlighting the break in opposite directions of Dow Theory lines by the averages. What almost everyone is talking about is the non-confirmation and its implication for the market. The opinions range from “the sky is falling” to “non-confirmations don’t mean anything” or even “Dow Theory is useless so this non-confirmation is nothing more than fodder for idiots”. I’ve been asked by one of the readers of Downside Hedge to share my thoughts on a recent blog post by a popular market commentator. His article was of the “useless fodder for idiots” variety. I’m happy to respond, but rather than call someone out I’ll focus on the general arguments I usually see against Dow Theory (which the “fodder for idiots” article touched on). The arguments against Dow Theory generally fall into

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Tale of Two Indexes

Dow Theory non confirmation

Over the past week the non-confirmation in Dow Theory between the industrials (DJIA) and the transports (DJTA) widened. Both indexes have been painting a line for over two months. Now both indexes have broken out of their lines. The problem is DJIA broke upward and DJTA broke down. This creates a non-confirmation that warns of a possible long term trend change in the near future (next several months…remember Dow Theory is about the very long term trend). Until this non-confirmation clears with the transports moving to new highs (and of course the industrials too) investors should be cautious about adding new long positions. On the other hand, if DJIA breaks the lower boundary of its range along with the transports then it will add a larger warning that the long term trend might be changing. Any low created after a break lower from the range in both indexes will create a new secondary low that will be the trigger point of a change from a bullish trend to a bearish

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Intermediate Term Indicator Strengthen

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Over the past week all of my core market health indicators have strengthened except for market risk. My measures of the economy strengthened enough to move slightly above zero. This means we’ll be adding exposure to the core portfolios. The new allocations will be as follows: Volatility Hedged portfolio: 100% long (since 10/24/14) Long / Cash portfolios: 100% long Long / Short portfolio: 100 long Here’s a chart with changes to the core portfolios over the past 18 months. Green is adding long exposure, yellow raising cash or adding hedges, red represents an aggressive hedge using an instrument that benefits from rising volatility. One thing of note is that my core indicators (which are intermediate term in nature) are currently at odds with some of the short term indicators I watch. For example, Trade Followers momentum from Twitter is currently issuing a consolidation warning. This indicates that even though we’re adding exposure the market may chop around or dip before it can move higher. Another thing of concern is that

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It’s All About the Range

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Another week gone and the market is still in a range. The S&P 500 index (SPX) has climbed back to the top of the range at 2120, while the Dow Jones Industrial Average (DJIA) and Dow Jones Transportation Average (DJTA) are lagging a bit. As I mentioned last week the direction of the break in SPX, DJIA, and DJTA will point the direction of the next intermediate term trend. So we’re left waiting again this week for confirmation of the uptrend or a rejection at the current level which will result in more time waiting. On thing I’m watching on a longer term scale is the continued negative divergence from several indicators. Negative divergences aren’t good timing devices for the simple fact that they can last for month or years, but they do provide important information if price declines. The percent of stocks above their 200 day moving average has been diverging from price for over two years (although from abnormally high levels). This indicates that market participants are getting

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More Evidence of Accumulation vs Distribution

Dow Theory Line

Earlier in the month I highlighted some technical analysis indicators that showed a battle between accumulation and distribution. As of Friday we have more evidence of a battle between people accumulating stock and distributing it. This evidence comes from Dow Theory. Friday’s decline in the Dow Jones Industrial Average (DJIA) created a Dow Theory line. Both averages are now showing a pattern that indicates either accumulation or distribution is underway, but we’ll have to wait and see how these patterns resolve to know which will win. William Peter Hamilton stated: When a ‘line’ is in process it is the hardest thing in the world to tell either the nature of the selling or that of the buying. Both accumulation and distribution are at work, and no one can say which will ultimately exercise the greatest pressure. When the pattern is broken we’ll have an answer that will have a significant impact on the market. Hamilton said that the break of a line will indicate a change in general market direction

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Caution Sign From Dow Theory

Published on April 6, 2015 by in Dow Theory
Dow theory Line

At the end of February I noted that Dow Theory had created a non confirmation. In that post I mentioned that I wouldn’t care about it unless the transports (DJTA) fell below their January lows. On Thursday of last week the January lows were broken. This is our first caution sign from Dow Theory. What makes the warning more significant is that the transportation average has been trading in a tight range since the first of the year. This tight range is called a Dow Theory line. The break below the bottom of the range creates a warning, but a major tenet of Dow Theory states that both averages must move together. The industrial average (DJIA) still hasn’t created a low that is three weeks away from its early March high. In addition, it isn’t painting a line. When both averages paint a line then break out (either higher or lower) the event is considered significant in Dow Theory. Since that hasn’t happened it leaves us with a small warning

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The Long View

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As long time readers know, I usually focus on intermediate term indicators because our core portfolios attempt to catch intermediate term up trends (and avoid large draw downs). I don’t often focus on long term indicators so I thought it would be good to step back a bit and see what the very long term indicators are telling us. For the most part they are still showing healthy readings that indicate a long term bull market, but they’re starting to stall. Over the past month the monthly MACD for the S&P 500 Index (SPX) has be crossing back and forth between a bullish and bearish cross. Momentum for SPX is diverging from price as well. As you can see from the chart below, these two indicators have been losing strength for well over a year. For that reason, they aren’t very timely so instead of using them to indicate portfolio allocation changes I use them as warning to watch intermediate term indicators more closely. Looking at SPX on a weekly

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Dow Theory Non Confirmation

Published on February 23, 2015 by in Dow Theory
Dow Theory Non Confirmation

Last week the Dow Jones Industrial Average (DJIA) moved above its previous peak, however the Dow Jones Transportation Average (DJTA) remained below its own. This divergence between the two indexes has created a Dow Theory non confirmation…but it doesn’t matter…yet. A lot of Dow Theory proponents make a big deal out of non confirmations, but all non confirmations are not equal. The type that just happened where one average makes a new high and the other trails is what should happen. It would be extremely odd if both averages always moved above their previous peaks on the same day. When you see others suggesting that danger looms because the transports haven’t broken out yet don’t panic because this non confirmation gives us next to no useful information. A divergence that would make me sit up and notice would be if the transports started lower and broke below their January low. A condition where the industrials have made a new high and the transports are moving lower would be a warning

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Slower Downtrend

Published on February 3, 2015 by in Dow Theory
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One of the primary tenets of Dow Theory is that secondary movements tend to be more steep than the move they are retracing. For example, the Dow Jones Industrial Average (DJIA) made a secondary low point in June of 2012. The subsequent rally lasted four months. Then the next decline retraced 50% of the rally in only six weeks. This is typical behavior during long term bullish trends. What happened next isn’t typical. The market had a continuous rally lasting more than two years without a secondary reaction. This is because no price declines over that period retraced at least 33% of the move in a period lasting more than three weeks. We’ve now reached a point where both averages have declined for over a month. The fact that this decline has lasted over a month but is only down roughly 5 to 6% shows a market that is changing character. Instead of quick declines and retracements (V bottoms) we’re now seeing some sideways to slowly down consolidation. If the

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Dow Theory Best Indicator Since 2009

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Out of the lows in 2009 there has only been one of the indicators that I follow that hasn’t had whipsaws or bad signals somewhere along the way. That “indicator” is Dow Theory. It has continued to confirm  a long term bull market for the entire period from its bullish trend change in July 2009. This is due to time being an important factor in Dow Theory. The system outlined by Charles Dow and William Peter Hamilton waited for roughly three weeks of trend before declaring a secondary reaction point. The lack of secondary lows that subsequently failed has kept Dow Theory bullish. On the chart below I’ve annotated the secondary low and high points from the last several years. In addition there is a Dow Theory line during the first several months in 2012. We’re now approaching a month long decline in the Transportation average (DJTA). The industrial average (DJIA) will need to break below the December lows to pass the three week mark. At this point we’ll need

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