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Thursday, 17 June 2010

Avoiding a Death Sentence

by Mark Hulbert

The Dow Theory jury is still out.

But we at least know more than we did as recently as late May. According to one of the three Dow Theorists I monitor, precise parameters are now established for what the bull must now do in order to avoid a death sentence. The second of these Dow Theorists appears to agree.

The third member of the jury, however, has already said he is voting for that death sentence.

So the bull market has its work cut out for it to keep even this shred of hope alive.

The Dow Theory, of course, is the oldest market timing system still in widespread use today. Although its adherents don't always agree on its interpretation — as is the case now — the Theory has received an academic seal of approval for having beaten a buy-and-hold in the past. So it behooves us to pay attention to what the Dow Theorists are saying.

You might wonder why there is any room for disagreement in the first place. The reason is that the Dow Theory's creator — William Peter Hamilton, who introduced the approach in numerous Wall Street Journal editorials over the first three decades of the last century — never codified his thoughts in a set of complete and precise rules.

Consider the three Dow Theory preconditions for a sell signal. Though they are clear enough as far as they go, they still leave an enormous amount of room for interpretation — especially in the definition of "significant" in Step #2 below:

• Step #1: Both the Dow Jones Industrial Average (NYSE: ^DJI - News) and the Dow Jones Transportation Average (NYSE: ^DJT - News) must undergo a correction from joint new highs.

• Step #2: In their subsequent "significant" 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.

Consider how these rules applied to the situation immediately after the so-called "Flash Crash" in early May. Following the lows that both the Dow industrials and Dow transports hit on May 7, both indexes rallied — gaining 5.0% and 8.4%, respectively. But in that rally, neither average was able to surpass its earlier highs. And then, on May 20, both proceeded to break below their May 7 lows.

Richard Russell, editor of Dow Theory Letters, interpreted this sequence of events to unambiguously satisfy all three steps of this sell-signal process. Writing after the market closed on May 20, he wrote: "The curse, it is cast. ... [The breaking of the May lows] means that the primary bear market is resuming. The monster is creeping toward Bethlehem."

And in the several weeks since then, Russell has become even more apocalyptic in his pronouncements.

But Jack Schannep, editor of TheDowTheory.com, and Richard Moroney, editor of Dow Theory Forecasts, argued that the market's rally off its May 7 lows was too short to count as "significant" — it lasted just three trading sessions, in fact. On their interpretation, therefore, the market throughout May was stuck in the correction that constitutes Step #1 — two steps shy of a sell signal.

What about this month's rally, which began on June 7? After Tuesday's impressive triple-digit increase, that rally has now lasted six trading sessions and tacked 6.0% onto the Dow Industrials and 10.6% onto the Dow Transports.

Schannep, for one, thinks that's enough to be "significant." On his interpretation, that therefore starts the clock ticking: If both averages now proceed to close above their highs of six weeks ago, then the bull market will receive another lease on life.

But if they fail to surpass those highs and then close below their June 7 lows, then Schannep (and perhaps Moroney) would join Richard Russell in declaring a primary bear market to be in force.

In the meantime, according to this interpretation, the market is in the "no man's land" between reconfirming the previous bullish signal and declaring a fresh new bear market signal.

This indecision will no doubt frustrate investors who want black-and-white certainty in their market timing judgments. But, given recent volatility, it is a situation that is likely to be resolved in the very near future.

Fasten your seatbelts and hold on for the ride.

Mark Hulbert is the founder of Hulbert Financial Digest in Annandale, Va. He has been tracking the advice of more than 160 financial newsletters since 1980.
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