The Dow Theory Update November 16
By Tim W Wood CPA, November 16, 2007
Back in August when both the Industrials and the Transports moved down below their June lows, many were calling that a Dow theory sell signal. I wrote here in early August that this was not the case. It is now time for another update on Dow theory.
First, let's begin with a direct quote from Robert Rhea, who was the leading Dow theorist in the late 1920's and 30's.
"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."
For the record, the joint highs, which were last made back on July 19, 2007, served as the last confirmation of the Primary up trend. As stated above, I know that as the averages began to slide into the August lows, many were calling that decline a Dow theory sell signal. I explained back in my August newsletter that the decline, that was then just beginning, was rather a decline into a higher level Secondary Low Point. This has since proven correct and it is the price action since the August Secondary Low Points that is now important. So, let's now look at that price action from a Dow theory perspective.
As you can see in the chart below, the Transports have failed to confirm the Industrials advance in October to new highs. As a result, a Dow theory non-confirmation was born, which serves as a warning that something is wrong. In this case, this warning that has been screaming for a month now and it seems that few are listening.
Here are a few quotes from the great Dow theorists of the past on the subject of non-confirmation.
William Peter Hamilton - "The movement of both the railroad (now the Transports) and industrial stock averages should always be considered together. The movement of one price average must be confirmed by the other before reliable inferences may be drawn. Conclusions based upon the movement of one average, unconfirmed by the other, are almost certain to prove misleading."
William Peter Hamilton - "Dow's theory stipulates for a confirmation of one average by the other. This constantly occurs at the inception of a primary movement, but is anything but consistently present when the market turns for a secondary swing."
William Peter Hamilton - "When one breaks through an old low level without the other, or when one establishes a new high for the short swing, unsupported, the inference is almost invariably deceptive."
William Peter Hamilton - "Indeed it may be said that a new high or a new low by one of the averages unconfirmed by the other has been invariably deceptive. New high or low points for both have preceded every major movement since the averages were established."
William Peter Hamilton - "The two averages may vary in strength, but they will not vary materially in direction especially in a major movement. Throughout all the years in which both averages have been kept, this rule has proved entirely dependable. It is not only true in the major swings of the market, but it is approximately true of the secondary actions and rallies. It would not be true of the daily fluctuations, and it might be utterly misleading so far as individual stocks are concerned."
Robert Rhea - "The most useful part of the Dow theory, and the part that must never be forgotten for even a day, is the fact that no price movement is worthy of consideration unless the movement is confirmed by both averages."
Robert Rhea - "The Dow theory deals exclusively with the movement of the railroad and industrial stock averages, and any other method would not be Dow's theory as expounded by Hamilton."
Robert Rhea - "A wise man lets the market alone when the averages disagree."
Robert Rhea - "When the averages disagree they are shouting 'be careful'."
Now, should the Industrials close below their August Secondary Low Point, as the Transports now has on several occasions, such price action would serve not as a Dow theory sell signal, as so many seem to believe. Rather this would serve as confirmation that the Primary Trend has turned bearish. In other words, just as Rhea explained above, once the trend is authoritatively established as bullish, which it has been, that trend "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." Point being, the current non-confirmation is an indication that something is wrong and actually serves as what Rhea called "Sell Spots." I'll cover more on this below. Anyway, the previously existing Primary up trend remains intact and will unless/until the Industrials confirm the Transports.
Now, I want to talk about what Rhea called "Buy and Sell Spots." Many would call any subsequent break from this point by the Industrials below the August lows as a Dow theory "Sell Signal." As explained above, this is a misconception and is a very common mistake by those who have not studied the Dow theory in detail. The great Dow theorists of the day had what they called "Buy Spots"and "Sell Spots" in which they would take positions. These Buy and Sell Spots occurred at areas in which they anticipated a reversal as a result of say non-confirmations like we now have. These anticipated reversals would come before the confirmation of the Primary Trend change actually occurred. I can assure that the Dow theory masters did not wait until the Primary Trend confirmation occurred to take positions. It was the breaking of the previous Secondary High or Low Point that was used to confirm their Buy and Sell Spots as well as to establish the Primary Trend change.
So, what constitutes Buy and Sell Spots? Simplistically stated, this occurs when failed rallies or failed declines occur and an anticipated Primary Trend change is at hand. Given that the Industrials have begun to fade from their October highs, along with the lagging Transports, we have been in what Rhea would have called a Sell Spot since early October. Now that the Transports have violated their previous Secondary low point, this ongoing "Sell Spot" is gaining momentum and should the Industrials break below their August Secondary Low Point, that break would in reality serve to establish the Primary Trend as bearish.
Tim W. Wood
© 2007 Tim Wood