The Tell: Bear market or just another correction? Dow Theory may hold the clues, analyst says

Investors and analysts are vigorously debating whether this stock-market downturn is just another garden-variety slump, among a number littering the pathway of the current history-setting bull run.

Tyler Richey, co-editor of the Sevens Report, for one, says that Dow Theory may offer the clearest warning sign for market participants.

Dow Theory, often followed by die-hard, chart watchers on Wall Street, is based on the 100-year-old idea that tracking the performance of Dow Jones benchmarks can provide clues about future market direction.

Right now, Richey says, Dow Theory indicates that “we are getting much closer to a bear-market signal than we were just a few weeks ago.”

The Dow Theory is a market timing tool that is triggered when both the Dow industrials and transports close at a lower low after a lower high. Traditionally a Dow Theory sell signal is triggered in three phases, according to MarketWatch columnist Mark Hulbert: 1) when both the Dow benchmarks fall substantially from a recent high; 2)., when they fail to rally above that high, and 3)., when both fall below their recent lows.

The first flashes to emerge from technical analysis of the Dow Jones Industrial Average

DJIA, +1.44%

was after the Dow posted an all-time weekly ( high during the week of Sept. 21st at 26,743.50, according to Richey, “underscoring the bullish trend in the broad market.” Since then, the Dow has logged both a lower high the week of Nov.9 and a lower low when it closed out the week ended Nov. 23 at 24,285.95. Richey uses the weekly closing averages of the benchmarks in tracking Dow Theory formations, but many chart watchers use daily closes (see chart below):




Meanwhile, the Dow Jones Transportation Average

DJT, +1.05%

also peaked at an all-time weekly closing high in September, before hitting a low on the year of 9,965.67, on the week ended Oct. 26.

Thus far, transports have rebounded in what looks to Richey as “a failed attempt to reach new highs,” before falling more than 2% over Thanksgiving week. “If Transports hit a new low in the coming weeks,” Richey said, then Dow Theory suggests that investors should prepare for, at best, a sideways moving market. At worst, it could signal that today’s market correction could evolve into a full-blown bear market, in short order.

Dow Theory was created by William Peter Hamilton, then the editor of The Wall Street Journal, who introduced his theory in stages over several decades in editorials in his newspaper.

“The broader market can’t rise for long without industrial stocks and transport stocks moving higher together,” Richey said. “We could have a protracted sideways move, but it’s unlikely the market moves higher without new highs in both industrials and transports,” Richey said, adding that a new low in transports would be a very bearish signal.

While it’s true that Dow Theory is viewed as outmoded by some, advocates, including Richey, say that these signals are still worth monitoring.

He points to 2015, when similar bear patterns formed in the Dow transports, which preceded eight months of volatility and a 12% correction in the Dow. “If investors had followed those signals in 2015 to get out, and buy signals leading up to the 2016 election to get back in,” they would have been saved a lot of pain in between, Richey said.

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