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DOW Theory Shows Bulls are Firmly in Control

“CHAPEL HILL, N.C. (MarketWatch) — The Dow Theory—the oldest stock-market timing system in widespread use — remains bullish.

The Dow Theory, for you history buffs, was introduced gradually over the first three decades of the 20th century in editorials in the Wall Street Journal by its then editor, William Peter Hamilton. The three preconditions for a sell signal that he set out are:

  1. •Step #1: Both the Dow Jones Industrial Average and the Dow Jones Transportation Average must undergo a “significant” correction from joint new highs.
  2. •Step #2: In their subsequent “significant” rally attempt following that correction, either one or both of these Dow averages must fail to rise above their pre-correction highs.
  3. •Step #3: Both averages must then drop below their respective correction lows

To be sure, though these steps might appear to be clear enough, they still leave room for interpretation. Among the three Dow Theorists I follow, for example, there is disagreement about whether step #1 has even been satisfied by recent market action.

That’s because it’s not clear whether the stock market’s recent decline qualifies as “significant.” It sure felt significant last week, especially on Thursday when the Dow fell by more than 300 points.

But the rule of thumb that many Dow Theorists employ is that, to be “significant,” the correction needs to last at least three weeks and retrace at least one-third of the previous move.

That would rule out what we’ve seen since the July market highs, of course; that decline so far has lasted just eight trading sessions for the S&P 500 SPX -0.32% and 13 for the Dow Jones Industrial Average DJIA -0.28% — and led to losses of less than 4% for each index.

On that interpretation, therefore, not even the first of this three-step process has been triggered. Richard Moroney, editor of Dow Theory Forecasts, is in this camp, writing that the Dow Theory is “unambiguously bullish.”

Jack Schannep is also bullish, though he does think step #1 has been satisfied. That’s because he believes that, in order for the Dow Theory to be relevant to the 21st century, it must be modified to acknowledge that market movements — even significant ones — occur more quickly than they did when Hamilton introduced his theory a century ago. And Schannep’s modified version of step #1 has been triggered; he is therefore focusing on the second of the three-step process for a sell signal.

Reasons for optimism….”

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