Dow Theory: Levels to Watch

09/17/2015 9:00 am EST

Focus: STOCKS

Richard Moroney

Editor, Dow Theory Forecasts

Developed in the late 19th century, Dow Theory is a market timing system created by Charles Dow. Dow Theory Forecasts, a newsletter published since 1946, continues to track this model. Here, editor Richard Moroney updates the status of this legendary timing signal.

With the Dow Theory in the bearish camp, investors should maintain a defensive posture.

Stocks have bounced, with China’s moves to stimulate its flagging economy triggering some bargain hunting.

Just as there are secondary corrections in bull markets, there are secondary rallies in bear markets.

Even when underlying fundamentals are deteriorating, stocks will periodically rally in bear markets when sentiment gets overly bearish.

Every bear-market rally could potentially represent the first stage of a new bull market.

To differentiate between these two possibilities, Dow Theorists look at the market averages’ ability to hold above previous significant lows and penetrate significant highs.

In the near term, the market’s ability to hold above its August 25 closing lows of 15,666.44 in the Dow Industrials and 7,466.97 in the Dow Transports will be crucial.

If both averages move below these lows, the bear market would be reconfirmed.

But if one or both averages can hold above these lows on the market’s next downdraft, the first criterion for a return to the bullish camp would be satisfied.

At that point, a rebound in both averages above previous significant highs would represent a bull-market signal.

Also, if both averages rally to all time highs without interruption, we’d have to conclude that the August 20 bear-market signal was incorrect.

A return to all time highs would require rallies of roughly 12% in the Industrials and 15% in the Transports.

Our intermediate potential risk indicator, based on the percentage of NYSE stocks trading above their 200-day moving averages, suggests stocks remain oversold and could have further to bounce in the near term.

Sentiment also suggests the recent bounce could be extended, as individuals and advisers are quite bearish.

Therefore, sentiment indicators suggest the rally may have further to run in the near term. But at least one average will need to hold above the August 25 closing lows for a return to the bullish camp.

For now, we intend to hold an above-normal cash position until both averages reach significant highs. Our current Long-Term Buy List has 70% exposure to stocks.

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