There are plenty of reasons to paint a bullish or bearish picture of the markets, but the Dow Theory has been around a long time and is moving toward a sell signal for stocks, warns Richard Moroney of Dow Theory Forecasts.

Does it make sense to exit the US stock market because you don’t like this month’s election results? Probably not.

Does it make sense to reduce your stock-market exposure because the stock market doesn’t like the results? Yes, potentially.

For those who see a contradiction in our answers, we make four points:

  • The US stock market, as reflected in market averages like the Dow Industrials and Dow Transports, is an unbiased, comprehensive, and ruthless reflection of everything expected to impact returns on US-traded stocks. You, on the other hand, are a human and therefore vulnerable to the cycles of fear and greed that can cloud the judgment of even the best investors.

As founding Dow Theorist William Hamilton wrote in 1912, “The average discounts everything—volume, general conditions, dividends, interest rates, politics—and just because it is an average, it is the impartial summing up of every possible market influence.” When both the Industrial and Transportation averages are trending lower, history suggests the market is discounting leaner times ahead.

  • While identifying the market’s primary trend is sometimes difficult, a break below the June closing lows of 12,101.46 in the Industrials and 4,847.73 in the Transports would be a clear indication.

After reaching highs that were clearly significant early this year, both averages suffered springtime corrections that were clearly significant. Those corrections terminated at the June lows, and since then the Transports have been unable to confirm new highs in the Industrials. That means a break below the June lows would be a textbook bear-market signal.

  • Government policies that are good for the average US voter may not be good for US stock returns, and vice versa. With future treatment of dividends and capital gains unclear, stock prices will reflect expectations for both corporate earnings and the net returns investors can expect to realize after taxes.
  • Seldom have the workability of our legislative process and the competency of our elected leaders been doubted so widely. With elections completed and the deadline of the fiscal cliff looming, the US government faces a crucial test. Will we go the way of Europe, unable to do what’s best for the whole because of divergent interests and divergent world views? Or will we get it together?

The stock market will be watching.

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