A number of analysts and advisory firms have recently made the case that Dow Theory has issued a sell signal, indicating that the major trend of the market is now down. Let's examine the price action driving these calls to see if we agree with that interpretation.
Mechanically speaking, a traditional Dow Theory sell signal is predicated on three developments: First, the Industrial and Transport averages must undergo a significant correction from new highs. Then, during the subsequent rally, one or both of the averages must fail to recover above their prior highs. Finally, both averages must fall below their prior correction lows.
This sounds relatively straightforward, so what causes the varying degrees of uncertainty regarding whether a signal has been triggered? Typically it comes down to an interpretation of what is deemed "significant." You'll see what I mean momentarily.
Those who contend that Dow Theory has issued a sell signal are basing that call on the following price action. The first chart below shows the daily action of the Industrials. As denoted in the chart, we see the Dow decline from its previous high set it December to an initial correction low near 17,300. The subsequent rally fails to surpass the prior closing high, and then we see a drop below the prior correction low.
A similar setup can be seen in the Transports. Prices declined from the December high to near 8650, attempted to recover but failed, and then dropped below the mid-January correction lows. It may not appear from the chart that the Transports took out their prior low, but the closing price on January 30th was in fact 6.62 points below the January 15th low.
Based on the above, it can be argued that yes, Dow Theory has issued a sell signal. Do I agree with that call? Not really.
I'll get into why momentarily, but let's talk holistically for a moment. Dow Theory and many other chart patterns in technical analysis are fundamentally based on the concept of using "lower highs and lower lows" or "higher highs and higher lows" to identify the direction of trend.
In fact, the three criteria required for a Dow Theory sell signal are exactly the same three criteria required for price action to trace out a series of lower highs and lower lows. After an initial correction, the subsequent rally attempt that fails to recover the prior high creates the first "lower high" and a subsequent fall below the prior correction low means that regardless of where prices bottom from there, it will create a "lower low." You can see this visually in the charts above.
Another very common chart pattern in technical analysis, the head-and-shoulders top, relies on the exact same logic. The diagram below shows a classic head-and-shoulders top formation in gray. I've added the annotations in green and red to show the transition from "higher highs and higher lows" before the market top, to "lower highs and lower lows" after the top. This is one of the most reliable and well recognized chart patterns in technical analysis, yet when you break it down, it too is based on very simple logic.
For those who want to keep things simple and leverage much of what technical analysis has to offer without memorizing a bunch of chart patterns, use this basic concept: A series or rising lows and rising highs is bullish, and a series of lower lows and lower highs is bearish. When you see the pattern change, it's probably time to reassess your positioning. You could even take it one step further and apply the wisdom Dennis Gartman has used for years: If the chart goes from the lower left to the upper right, it's bullish, and if it goes from the upper left to the lower right, it's bearish.
Now back to Dow Theory ...
The main reason that I'm not completely onboard with the call that Dow Theory has issued a sell signal and the major trend is now bearish comes down to my interpretation of "significant." What is a "significant" correction anyway? Is it a function of the percentage drop from prior highs? Or the duration of that drop? Some combination of the two? And what constitutes a "significant" attempt at new highs?
To be honest, there are no concrete answers to those questions. This is where judgment comes into play.
One of the main tenets of Dow Theory is that there are three trends in the market. The first is the primary trend, which is the major trend of the market. This is the overriding trend that can last for years and has the largest effect on long-term prices. Within the primary trend is the secondary or intermediate trend, which often lasts from a few weeks to a couple months, and then finally the minor trend which encompasses the daily movements.
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The concept of using lower highs and lower lows to identify a bearish change in trend can be applied on many different scales. For example, we could pull up a 5-minute chart (an intraday chart where each bar represents price changes over a 5-minute period) and watch for a series of lower highs and lower lows to develop in both the Industrials and Transports. We could then say that the "trend is bearish," but how valid is our assessment on the primary trend? It's based on such a short period of time that really all we're looking at is noise.
As we zoom out on the chart and apply this logic across longer and longer time-scales, our assessment becomes more indicative of longer-term price moves ... those that would comprise the primary trend, not the secondary or minor trends.
It is this concept of scale that leads me to believe that currently, the recent action of the Industrials and Transports is not sufficient to support a call that the primary trend of the market has officially transitioned from bullish to bearish.
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If you look at the first two charts presented, you can see that the subsequent rally in which the averages attempted to recover their prior highs lasted four days. Following that, the decline below initial correction lows took four days for the Industrials and six days for the Transports. In my opinion, price action over this timeframe is much more indicative of a bearish secondary trend than a bearish primary trend.
In summary, what I believe all market-watchers can agree on is that the upward momentum in the market has stalled. It's been over a month since any of the major averages have recorded new highs, and we're seeing the 50-day moving averages trend flat with perhaps a minor downward bias. Those making the call that Dow Theory has issued a sell signal have ground to stand on because the three criteria required have in fact been met. My hesitance in making the same call has to do with the time frame over which the sell signal has developed. Personally, I believe most of the daily action we're seeing fits into the category of noise with regard to the primary trend. We have a lot of macroeconomic events stirring up volatility in the markets and I prefer to exercise more patience before confirming that the primary trend is bearish.
The following was an excerpt of Richard Russell's Dow Theory Letters. To receive their daily updates and research, click here to subscribe.
