Dow Theory and Stock Market Update

By: Tim_Wood

Many proclaim that the recent decline below the June 2007 lows by the Industrials and the Transports served to trigger a Dow theory sell signal. Based on the evidence as I read the averages, this is not the case.

The extended advance up out of the 2002/2003 lows has proven to be one of the longest advances in stock market history. As a result, it has proven that the single most important aspect of Dow theory is price and that what we may perceive as value or a given market phasing is in fact secondary. In other words, price itself is the single most important aspect of Dow theory and the old time Dow theorists knew it.

In Robert Rhea's work titled The Story of the Averages , it is made very clear by the numerous examples that confirmation of a Primary up trend occurs when both averages better their previous Secondary High Point and that a Primary down trend is established when both averages violate their previous Secondary Low Point.

Moving on to the chart below and according to this basic principle of Dow theory, the Primary Trend turned up, or in Rhea's words it was “authoritatively established as bullish,” way back in June 2003 when the 2002 Secondary highs were bettered. Since that time the averages have made six consecutively higher advances. Each of these advances have established yet a higher Secondary High and Low Point with the last joint closing high that occurred on July 19 th having marked the 6 th Secondary High Point since the 2002/2003 lows. Many are looking at the joint decline below the June 2007 lows as having violated the previous Secondary Low Point and thereby confirming the Primary Trend as being down.

I do not believe this to be correct because the June lows were not, in my opinion, sufficient enough to be classified as having marked a Secondary Low Point. It is my belief that the decline from the July 19 th joint high marked the beginning of the decline into a new Secondary Low Point. Thus, the market is still fishing for the next Secondary Low Point and at this time the previous Secondary Low point also remains intact. Therefore, from my perspective of Dow theory, the Primary Trend remains bullish.

We also find in Robert Rhea's writings this specific quote about the transition between bull and bear markets. “Under Dow's theory the primary trend, once authoritatively established as bullish, is considered to be continuing in force until negated by a confirmed bearish indication such as would be the case when, after a reaction of full secondary proportions in a bull market, a rally fails to lift both averages to new high ground, and a later decline carries both averages below the preceding secondary low.”

If we apply what Rhea is saying here to the current market, the averages would first have to establish a Secondary Low Point, which again I believe it is now doing. Then, from that low the averages will have to fail to better the July 19 th highs and then turn down below the Secondary Lows that are now being established in order to confirm that the Primary Trend has turned from bullish to bearish.

Therefore, based on the fact that the averages have not yet violated their previous Secondary Low Points nor have the averages experienced a failed rally followed by a decline below their previous Secondary Low Points, I cannot find justification to say that the Primary Trend, in accordance to the Dow theory, has turned bearish.

Now, looking at the market from a cyclical and statistical perspective, which has absolutely nothing to do with Dow theory, all indications continue to suggest that the market is extremely over extended in what has now become the second longest advancing 4-year cycle in stock market history. The Dow theory simply has not confirmed a Primary Trend change at this point. Anyway, this extended move has obviously been fueled by the liquidity campaign to keep the market advancing.

However, even the Fed can only do so much. The intermediate-term internals have been fading as the markets “broke out” into their recent new highs. New lows are registering readings not seen in years and the intermediate-term breadth indicators that I follow have been weak for months. The issue now is that the market has become so stretched on such weak internals that it is becoming increasingly harder to keep the advance going. I believe that the Fed understands the house of cards very well and an example of this came with the massive liquidity infusion reported by CNBC on Thursday when the market once again began to soften. There are two noteworthy points to be made here. One, the Fed knows the danger of the market and stepped in with the liquidity to try to save it on Thursday, but it still fell some 387 points.

So, it is getting harder and harder to save. Two, if the market wasn't at great risk do you think the Fed would be taking the measures that they are? No, they are afraid to let any reasonable correction begin because they know the risk of an implosion. Maybe the market can be saved again and maybe it can't. But, it really doesn't matter because even if it is saved again, it will be on even worse internals and create even greater complacency. The market is stretched well beyond any historical norm and this cannot continue forever. Ultimately the Fed is fighting a losing battle. The internals stink and the decline into the now very extended 4-year cycle low is coming and there will ultimately be nothing the Fed can do to stop it. You have been warned!

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By Tim Wood
Cyclesman.com

© 2007 Cycles News & Views; All Rights Reserved
Tim Wood specialises in Dow Theory and Cycles Analysis - Should you be interested in analysis that provides intermediate-term turn points utilizing the Cycle Turn Indicator as well as coverage on the Dow theory, other price quantification methods and all the statistical data surrounding the 4-year cycle, then please visit www.cyclesman.com for more details. A subscription includes access to the monthly issues of Cycles News & Views covering the stock market, the dollar, bonds and gold. I also cover other areas of interest at important turn points such as gasoline, oil, silver, the XAU and recently I have even covered corn. I also provide updates 3 times a week plus additional weekend updates on the Cycle Turn Indicator on most all areas of concern. I also give specific expectations for turn points of the short, intermediate and longer-term cycles based on historical quantification.

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