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Dow Theory

Written By Brian Hicks

Posted June 4, 2009

As I wrote last week, wisdom is where you find it.

And while I admit that is a tad generic, finding wisdom is the easy part as long as you’re willing to look for it.

However, actually following the words of the wise is another matter entirely, since they always seem to be a whole lot more prophetic in hindsight. Even still, more often than not, it pays to know the opinions of people who "have been there and done that."

That’s why when guys like Richard Russell have something to say about the direction of the markets, people listen.  

After all, Russell has not only seen it all, but he also has the market-calling history to back it all up. For him, this recession is just the latest in a long string of them.

His market prism — as always — has been Dow Theory, which has served as the very basis of technical analysis for over 100 years.

Using Dow Theory to Predict Price Action

Created in part by Charles Dow himself, Dow Theory is a market system that uses trend analysis to chart which way the market is headed.

In fact, in the simplest terms, it is a system which basically says the market is in a bullish trend if one of its averages — either the Dow Jones Industrial Average (^DJI ) or the Dow Jones Transportation Average (^DJT) — advances above a previous important high and is followed by a similar advance in the other.

Conversely, the theory also states that when both averages fall below previously important lows, the market is in a bearish trend.

The logic behind this, of course, is pretty simple. You see, Dow believed the general performance of the stock market was a reliable way to forecast the overall business conditions within the economy. 

Thus, if one could accurately gauge the price performance of the broader markets, a bullish or bearish trend could be established — along with the likely direction of individual stocks.

In this regard, Dow theorists closely watch the price action in the transportation and industrial averages, since the overall broad market trend must be confirmed by their moving in tandem on increasing volume. One moving without the other, to Dow theorists, is a false signal.

In fact, if one index does not confirm the other, then it is a warning sign that the current trend may be over and positions may need to be liquidated.

Of course, the reason for identifying the trend is to trade with it, not against it. After all, that is how good traders manage to stay ahead of the markets.

These trends, according to Dow theorists, are either primary or secondary.

The primary trend is more vital, generally lasting for one to three years. In short, it’s the longer-term trend which is either bullish or bearish.

Along with it are the secondary or countertrends that occur along the way, since no market goes either straight up or straight down. As such, these move in the opposite direction, producing either bear market rallies or bull market corrections. Typically, these can last from anywhere from three weeks to three months.

Knowing the difference, of course, is what trading the trends all is about.

Richard Russell’s Market Call

But short of being a market technician yourself, there is always the judgment of Richard Russell. He has seen enough of both these trends to have an educated opinion on them.

Here’s what he wrote about the state of the markets in April, as the current rally was gathering steam:

The market situation has seldom been more confusing. Many analysts are convinced that we are in a new bull market. Others (me included) believe we are in a bear market correction (rally).

Because of the confusion, I’m going to step out and make a few guesses (might as well, since nobody really knows what’s going on).

1) I believe that we’re in a secondary (upward) correction of a bear market. I’m going to guess that this correction could rise further or at least last longer than most people are expecting. A bear market rally is supposed to convince the majority that a new bull market has started. The rally will often continue until a large number of investors are back on board, and then the bear will kill them as it fades away, leaving the new optimists high and dry and with losses.

2) Gold is in a downward correction of its primary bull market. Gold may decline or stall until it convinces the majority of gold-fans that the gold bull market has died. Holders of "paper gold" and gold futures and options will be frightened out of their holdings. What we’re experiencing now is the big correction that often occurs prior to the third speculative phase in gold. Holders of physical gold (coins, bars) will do best, since they will tend to hold on to their gold positions no matter what.

So what are the markets trying to do? They’re doing what they always do, keep investors in the equity bear market and keep investors out of the gold bull market. Why would they do that? Because that’s the very nature of markets. Markets tend to thwart the majority. And that’s logical and self-evident. If markets existed to make money for the majority, then most market participants would be millionaires, and we know that sadly, that is not the case.

So, in the view of a very wise man, the current run up is nothing more than a bear market rally. Meanwhile, the primary market trend remains bearish — unless you’ve invested in gold. (Russell thinks gold is about to enter the "mania phase.")

"This bear market will be deeper and longer than most people think," the legendary market watcher said recently. "People got optimistic too quick."

Great stuff, Mr. Russell.

As for the "Green Shoots," I don’t really see them either.

Your bargain-hunting analyst,

 steve sig

Steve Christ, Investment Director

The Wealth Advisory

P.S.  As always, gold is on the mind of our own Greg McCoach. As gold gurus go, he is one of the most insightful I have ever met.  Not suprisingly, he also thinks gold is about to enter its most specualtive phase. In fact, he has found a gold play so powerful he stalked it for months just to make sure it was real. To learn more about this opportunity, click here.