Dow Theory Update

Dow Theory has one of the best technical indicators for getting the longer-term trend of the markets “right.”

Now, Dow Theory is not known for calling tops and bottoms in the market, but rather providing the direction of the dominant underlying trend so that investors can capitalize on upswings and avoid downdrafts more effectively, which is why we study it and include it in the paid edition of The Sevens Report. 

For example, in recent history, following the signs of Dow Theory would have helped an investor avoid the tech bubble bursting, as well as the financial crisis beginning in 2008.

Specifically, Dow Theory signals were bullish coming into the late 90s before turning bearish on September 20, 1999, ahead of the tech bubble bursting, which saved Dow followers from 22% of the bear market of the early 2000s.

Signals again turned positive on July 7, 2003, where Dow Theory followers would have enjoyed 33% gains before signals turned back negative on January 14, 2008, before the real carnage of the financial crisis took place.

Dow Theory again turned positive in July 2009, in the early stages of the second-largest bull market in modern US history.

This can make a big difference in client returns because those investors and traders who abide by the rules of Dow Theory avoided those major pullbacks, and that helped them outperform in a huge way over the last 20 years.

In nominal terms (excluding dividends), passively investing in the S&P 500 since the late 90s, when Dow Theory turned negative, would have returned 40.22%. Meanwhile, investing based on Dow signals would have returned just over 145%.

Investment professionals need to take this with a grain of salt, because it is unrealistic to think that you could have clients invested 100% in cash especially when the market could potentially make new highs while you are sidelined (which happened with the tech bubble signal). But, the historical accuracy of Dow Theory signals demands respect, which is why we follow it for subscribers.

What Dow Theory Says About Today’s Markets

Looking at today’s markets, back in July 2015, Dow Theory offered the most-recent, bearish signal when the S&P 500 was trading at 2080 (basically about 2% from here). And, while stocks did eventually rally past that level, investors who got defensive were able to lessen the damage and more comfortably navigate the multiple pullbacks of between 5% and 12% in the last 15 months.

Dow Theory remains bearish right now as it has been since July 2015.

But, we are at a bit of an inflection point in the signals.

Dow Industrials have offered a bullish signal that is waiting to be confirmed by a higher high in the Dow Transports.

The level to watch now is 8086 in the Dow Transports, as a weekly close above that mark would confirm the bullish signal in the Dow Industrials (from early July), and effectively turn Dow Theory back positive, and that would be something to note for longer term investors.

But, the Dow Transports could easily fail to make that new high and in that case, Dow Theory would continue to flash a longer term warning sign for equity markets, and suggest the risk remains to the downside.

Bottom line, Dow Theory is at an important longer term inflection point, and we are going to be watching this closely for our subscribers and tell them if indeed a bullish signal is given, or if a decline in the Dow Transports reaffirms our cautious stance on stocks.

Technical Indicators Match the Fundamentals

When both technical and fundamental analysis are in agreement about the market, we take notice!

And, both are in agreement saying we are at a pretty important tipping point for 2016!

For the last eight weeks, we’ve been warning paid subscribers that evidence was mounting that bond yields could soon rise, and create a “cap” on the July stock rally at 2200 in the S&P 500.

And, that’s proven to be true. 

Now we are looking at two possible downward influences on stocks:

  • First, the market multiple may drop from 17X to 16X as bond yields rise.
  • Second, the 2017 earnings expectations may be reduced.

And, it’s not hard to see what kind of effect that can have on stocks:

So, if Q3 earnings don’t stabilize and soon, and bond yields don’t stop rising, then we could be looking at a “worst-case” decline of over 6% in the S&P 500 which could put the S&P 500 negative by as much as 3% heading into the final two months of the year! 

The key to successfully navigating this environment is to have a plan in place to protect client portfolios before the selling accelerates.

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