Dow Theory Sell Signal?

Dick Russell explained the situation in his always excellent letter dated October 26, 2009 (the brackets are my inserts). To wit:

“The secret of the direction of the great primary trend of the market lies in the secondary reaction and what happens AFTER a secondary reaction. A secondary reaction usually takes three weeks to three months in duration while correcting one-third to two-thirds of the previous move. Since the March low, we have yet to experience a true secondary reaction. And I'm wondering whether we could be on the edge of a secondary reaction now. Following a secondary (reaction), if BOTH Averages (Industrials and Transports) rise to new highs, the primary trend is taken to be bullish. Following the lows of a secondary reaction, there will be a rally. If (that) rally fails to take both Averages to new highs, and the Averages then turn down and break to new (reaction) lows, the primary trend is taken to be as bearish. Secondary reactions often start with one of the Averages sinking while the other Average continues to the upside.”

Well said Dick Russell. We, therefore, told our callers, “How can you have a sell-signal when we have not even experienced a downside secondary reaction since the March lows?” Indeed, you need a downside reaction, which “sets” the reaction lows, followed by a rally. If that rally fails to make a new reaction high, and subsequently breaks below the aforementioned reaction lows, then (and only then) will we have a Dow Theory “sell signal,” at least as I understand Dow Theory.

For the record, the recent closing price reaction “highs” are 10092.19 for the DJIA and 4045.11 for the DJTA. Measuring from those highs suggests a one-third “give back” would leave the DJIA at ~8910 and the DJTA at ~3412. That would be consistent with our comments in which we stated that we thought any correction would probably be contained between the 50-day moving average (DMA) and the 200-DMA. In the Dow’s case the 50-DMA is currently at ~9718 and the 200-DMA at ~8593, while the Transport’s 50-DMA resides near 3613 and the 200-DMA around 3269. Of course the markets can do anything, but I would be surprised if the Averages correct by more than one-third. Nevertheless, we have been pretty cautious since the latter part of September, fearing that the vacuum created by the July to September melt-up might get “filled” to the downside once quarter-end window dressing is over. Initially that strategy looked good, and then it looked bad; but all said, the Averages are only marginally below where they were when we turned cautious. Yet, we are still cautious.

The call for this week: When the going gets tough the tough go on the road. That’s what we did last week and that’s what we are doing again this week, so once again these will likely be the last strategy comments of the week. Nevertheless, last week’s “wilt” left everything we follow lower except for the U.S. Dollar Index. And while the DJIA (9712.73) averted a loss in October, none of the other indices we monitor did. Indeed, the S&P 500 (SPX/1036.19) slid 3.9%, bringing its two-week retreat to 5.6%. While our sense is that we are into a secondary correction, our proprietary overbought/oversold indicator is VERY oversold and the number of S&P 500 stocks that are above their 50-DMAs has fallen from more than 90% to 33.2%. Consequently, we continue to think it is a mistake to get too bearish. Ergo, until Dow Theory “tells us” otherwise, we think the primary trend remains UP, and we continue to trade, and invest, accordingly.

Source: raymondjames.com