As severe as the April–May correction has been, on a technical basis the primary bullish trend remains intact. I just wanted to point out a few things to our readers based purely on Dow Theory’s interpretation of trend. The goal is to remove emotion from the equation. Now, let's take a look at the stock market.
On a closing basis, we have created a new low. The S&P 500 February low closed at 1066 on February 5th. On June 7th the S&P 500 closed at 1050. Despite the fact that we've closed below the February low, I don't believe that the stock market's trend has reversed. In reviewing the six basic tenets to Dow Theory, it is quite clear that the market remains in a primary uptrend until more evidence can be obtained to the contrary.
There are six basic tenets to Dow Theory (as written in John Murphy’s Technical Analysis of the Financial Markets):
- The averages discount everything
- The market has three trends
- Major trends have three phases
- The averages must confirm each other
- Volume must confirm trend
- A trend is assumed to be in effect until it gives definite signals that it has reversed
The Averages Discount Everything
This is the basic market belief that the market is the sum of all knowledge, both past and present, that discounts the future's effects on today's market price. While the market cannot discount unknowable factors, such as terrorist attacks and natural disasters, the market quickly discounts such occurrences when they occur. This is one of the basic premises of technical analysis, that stock and market fundamentals are discounted in the current market price.
The Market Has Three Trends
One of the cornerstones of trend analysis is the "understood situation" in which a trend is created by successively higher highs and higher lows; and conversely, by lower highs and lower lows. When we say that the current trend has a lower low or a higher low, which low are we talking about? Well, the market has three trends according to Dow Theory: primary, secondary, and minor. Charles Dow used the analogy of the sea when comparing the three trends. The primary trend acts like the tide. The secondary trend is the waves within the tide. The final trend is the ripples on the waves. As each successive wave reaches higher up the beach, one could say that the tide was rising. If each successive wave receded lower down the beach, one could say the tide was falling. Market trends are followed in much the same way.
When looking at the current market trend (in place since March 2009), it is clear to me that each successive impulse wave has hit higher on the beach, indicating that the tide has been rising. However, the recent corrective wave has retraced more of the preceding impulse wave than any corrective wave that has come before it, which warns of a possible trend change.
Major Trends Have Three Phases
Within each trend, Dow saw three phases: the accumulation phase, the public participation phase, and the distribution phase. In the accumulation phase insiders and wise investors have anticipated the development of a new trend and have placed their investment early. The public participation phase occurs when the public discovers improving conditions, and as such, the price begins to rise sharply. The last phase of distribution is when insiders and wise investors sell into overly bullish speculation conditions and mania.
One indicator we can use to judge investor's participation is the ratio of Rydex bear and Rydex money market funds over the Rydex bull and Rydex sector funds. As this ratio increases, it signals investors are moving to the sidelines or betting against the market. As the ratio falls, it signals investors are beginning to participate in the market.
Currently, looking at the asset ratio of Rydex bear and money market funds in relation to their bull and sector funds, it's clear to see that investors have reached a level that has proven—over the past 10 years—to be intermediate-term selling exhaustion (around 1.10) on the Rydex asset ratio.
(The ratio has been inverted on the chart below)
Chart provided courtesy of www.decisionpoint.com
If we see a ratio any larger than 1.10, it would be an indication of panic and emotional selling where smart money would begin accumulating stocks. The last time we saw that kind of panic selling and smart money accumulation was in 2003, and 2009 to a smaller degree.
Looking at how high the indicator reached in April, it's not clear to me that we were in a zone of overly bullish participation in the stock market where smart money would begin distribution. The last time the Rydex asset ratio reached that overly bullish a level was in 2000.
Side note: Often, many contrarian wannabes get it wrong by taking the opposite trade of the public or by playing devil's advocate all the time. The dean of contrarian thinking, Humphrey Neill, explicitly wrote that the public gets the trend right MOST of the time. It's only at turns that the public gets the trend wrong.
The Averages Must Confirm Each Other
When talking about the averages confirming each other, Charles Dow was talking about the industrial and transport averages. Basically, both averages need to give the same signal. This happens when both averages create successive peaks or successive troughs. Dow didn't believe they had to happen at the same time, but the closer together, the better. When one diverged from the other, Dow believed the prior trend was still intact. Again, they have to both be giving the same signal.
Currently, both the Dow Jones Industrial Average (DJIA) and the Dow Jones Transport Average are reaching higher highs and higher lows since March 2009 to confirm a primary uptrend. As I said before, a new low was registered on June 7th for the DJIA, but I believe the heart of the law is that we have not created a new low. As John Murphy always talks about drawing support and resistance lines with a crayon to avoid whipsaws and statistical errors of 1–3%, in drawing a horizontal trendline from the February low through June, a low was not violated.
Industrials and Transports continue to confirm each other in a primary upswing
Technically speaking, let's consider the Dow Jones Industrial Average has reversed its trend with the new closing low created on June 7th. You'd still need the Dow Jones Transportation index to create a lower low to confirm the move in the industrials. Such a confirmation has not been made; and therefore, Charles Dow would presume that the prior trend remains intact according to this tenet.
Volume Must Confirm Trend
Volume confirms price. Essentially, volume expands in the direction of the trend. If the primary trend (or tide) was rising, one would expect volume to increase on the rising waves and decrease in the corrective waves; vice versa, one would expect volume to increase in falling waves and decrease in rallies during a primary downtrend.
Over the past two corrections, volume has decreased. While the market was climbing, volume increased. Both of these facts confirm a current primary uptrend.
A Trend is Assumed to Be in Effect Until It Gives Definite Signals That It Has Reversed
The final tenet of Dow Theory borrows from Newton's laws of motion. One of Newton's laws of motion states that an object in motion tends to remain in motion unless an external force is applied to it. The same is applied to a trend such that a market in a primary trend will stay in motion until an external force causes it to change direction. The last tenet of Dow Theory discusses how Dow Theorists search for "failure swings" and confirmations to give definite signals of a trend reversal.
A failure swing is one in which a primary trend fails to reach new highs in an uptrend or meet new lows in a downtrend. When a failure swing fails to break new ground, it's a warning of a possible trend change. When an uptrend produces a failure swing, the next step is confirmation when a new low is created; vice versa, confirmation is achieved in a downtrend when the market rises after a failure swing and creates a new high. Below is a chart of a primary uptrend in the Market Vectors Gold Miners in 2008 in which a failure swing warned of an impending trend change at the primary level. A definite signal was achieved in early August when the former low was violated.
Currently, I do not see a failure swing in the stock market at the primary trend level. Yes, soon after the Flash Crash, we rallied to a lower high, but I believe this was more on an intermediate-trend level. We have seen the same failure swing at an intermediate level in February 2010, October 2009, September 2009, and June 2009. Despite these intermediate corrections, the primary trend reached new highs soon after.
Let's say the stock market breaks down below 1050 this week and we bounce at 1000. All that would do would satisfy a new low, not a lower high. Many Dow Theorists wouldn't consider a trend reversal until the market rallied to point B to create a failure swing. At that point a break to point C would confirm the failure swing and register a sell signal. Choosing to sell on a failure swing or confirmation is a decision based on risk comfort.
Dow Theory has some legitimate criticism regarding its timeliness. Let’s say the chart above runs its course and we receive confirmation of a reversal of the primary uptrend in August. Well, if one failed to execute a defensive or bearish strategy until then, they would have missed out on a 15%+ move down in the stock market. Rather, Dow Theory is attempting to get the big moves right. Most trend following techniques are late by their very nature. It takes a whole toolbox of indicators to anticipate trend change accompanied by a little guesswork.
This wasn’t a market observation about market timing the ripples or the waves, but about timing the tide. One needs to look to other devices such as trend reversal signals, chart patterns, momentum changes, and psychological changes to determine if an external force is being applied to the markets to change the primary trend. Many could argue the case that Europe is that very force. So far, from a Dow Theory perspective, the market trend is still in an uptrend despite the severity of the May correction. The market is currently range-bound between the February low and the 200 daily moving average, which isn’t a very safe area for the market to be "finding itself". I believe the market wants to rally to the 50 daily moving average, but it’s lacking a catalyst right now.
