What Dow Theory says about the sell-off

By Mark Hulbert

May 21, 2010

ANNANDALE, Va. (MarketWatch) -- How now, Dow Theory?

Was Thursday's plunge enough to trigger a sell signal, indicating that a major bear market has now begun?

Or is the jury still out, which in effect means we should give the bull market the benefit of the doubt?

Those are crucial questions to ask of any market timer right now, of course. But there are several additional reasons to ask them of the Dow Theory.

One is that it is perhaps the oldest market timing system still in widespread use today. Another is that it has a stellar long-term record.

Yet another reason to ask these questions of the Dow Theory: According to two of the three Dow Theorists I monitor, the system is still on a buy signal. If they're right, then the Dow Theory is among the very last of technical trading systems still in this market -- since, especially after Thursday's market action, most of the others are now in cash. (Read commentary on Thursday's breaking of major support levels.)

You might wonder why there is any doubt as to whether a sell signal has been triggered. The reason is that the Dow Theory's creator -- William Peter Hamilton, who introduced the approach in numerous editorials over the first three decades of the last century in The Wall Street Journal -- never codified his thoughts in a set of complete and precise rules.

This failing becomes particularly evident in determining whether the three Dow Theory preconditions for a sell signal have, or have not, been met by the market's gyrations over the last month:

-- Step #1: Both the Dow Jones Industrial Average and the Dow Jones Transportation Average must undergo a significant correction from joint new highs.

-- Step #2: In their subsequent rally attempt following that correction, either one or both of these Dow averages must fail to rise above their pre-correction highs.

-- Step #3: Both averages must then drop below their respective correction lows.

Let me start with Richard Russell, editor of Dow Theory Letters. He believes that Step #1 was satisfied by the market's drop from its April highs to its May 7 low, and that Step #2 was satisfied by the failure of the two Dow averages, during the rally off those lows, to surpass their April highs.

And then, with both Dow averages closing Thursday below their May 7 lows, the sell signal has cleared Step #3.

As Russell wrote earlier this week: "If the May 7 lows are violated by the Industrials and Transports, I expect some severe downside action by the stock market. If that occurs, I would expect traders and investors to panic. I believe it will affect the sentiment of not only investors, but the sentiment of the whole nation. The current rosy optimism could fade and reverse in a week. It could fade because it is built on BS propaganda from the government and hopes on the part of the populace. The 14-month stock market rally has served to brainwash the nation."

"Not so fast" is the essence of Jack Schannep's response to Russell. Schannep is editor of a service called TheDowTheory.com. Schannep's interpretation of the Dow Theory did a better job of navigating the 2007-2009 bear market and subsequent bull market than any of the nearly 200 other stock market timing strategies monitored by the Hulbert Financial Digest.

Schannep believes, in contrast to Russell, that we're still stuck in Step #1 of the three-step process required to generate a Dow Theory sell signal. On his interpretation of how Hamilton's writings apply to today's markets, the initial pullback must last at least two weeks in order to move to Step #2 in this process. This turned out not to be the case:

"The S&P [500 index ] decline did last two weeks (barely)," he writes, "but the Dow Industrials were a day short and the Transports' decline only lasted four days." On Schannep's interpretation, therefore, this week's big plunge simply represents the continuation of the pullback that will eventually become Step #1.

That, in turn, means that the bull market's fate rests with how stocks do in their first significant attempt to rally off of whatever low is set during this pullback. If they fail in that rally to surpass the April highs, and then close at new lows, a sell signal will indeed be triggered.

But not until then.

The third Dow Theorist I monitor is Richard Moroney, whose service is entitled Dow Theory Forecasts. Though he has written relatively little recently about the specifics of his interpretation of the Theory, he did say earlier this week that because "this year's new highs [were] the last confirmed signal under the Dow Theory -- we are sticking with a mostly invested posture."

So there you have it.

One of the three Dow Theorists I monitor is firmly bearish -- along with most of the other technical analysts I follow. The other two are remaining bullish, despite the stock market's recent carnage.

If you don't find their reasons for remaining bullish compelling, then you may want to join the others who have already thrown in the towel.