Opinion: The Dow Theory is telling us to chill about the health of the bull market

This article was originally published on MarketWatch.com at http://www.marketwatch.com/story/the-dow-theory-is-telling-us-to-chill-about-the-health-of-the-bull-market-2017-08-22

CHAPEL HILL, N.C. — Did the bull market end on Aug. 7, when the Dow Jones Industrial Average and the S&P 500 closed at their all-time highs?

The Dow Theory is surprisingly sanguine in its answer: Maybe, maybe not.

However, this market-timing system is unambiguous about how we should behave: Since a definitive answer won’t be known for quite some time, we should give the bull market the benefit of the doubt.

In other words, we need to chill.

The Dow Theory is the oldest stock-market timing system that remains in widespread use today. It was created a century ago by William Peter Hamilton, who at the time was editor of The Wall Street Journal.

Before discussing what needs to happen for the Dow Theory to provide a definitive answer to whether the Aug. 7 high was the final top of the bull market, I need to acknowledge how surreal it is that so many investors are even wondering whether the bull market remains alive. After all, it was just a few short weeks ago — early July, in fact — that the Dow Theory declared the bull market to be alive and well. And, despite the market’s recent turmoil, the Dow industrials DJIA, +0.90%  and S&P 500 SPX, +0.99%  are just 2% below their all-time highs of 22,118.42 and 2,480.91, respectively.

The stock market must jump over three successive hurdles to generate a bear-market signal, and it hasn’t even cleared the first.

One reason so many investors are nevertheless concerned: The Dow Jones Transportation Average DJT, +0.87%   has nose-dived and is now 7% below its all-time high from mid-July. In the words of Richard Moroney, editor of Dow Theory Forecasts: “Historically, the economically sensitive Transports have often served as a canary in the coal mine, warning investors of a deteriorating outlook for the economy and corporate profits.”

Ominous though this sounds, however, Moroney and the other Dow Theorists I track are still bullish. That’s because the stock market must jump over three successive hurdles to generate a bear-market signal, and it hasn’t even cleared the first.

Those three steps are:

1. Both the Dow Jones Industrial Average and the Dow Jones Transportation Average must undergo a “significant” decline after hitting new highs — “significant” both in terms of time and magnitude.

2. In their subsequent “significant” rally following the decline referred to in step No. 1, either one or both of these Dow averages must fall to surpass their highs.

3. Both averages must then fall below their lows registered at the bottom of the decline referred to in step No. 1.

Notice that I put “significant” in quotes. That’s because there isn’t universal agreement on what magnitude of market moves is necessary to satisfy. Some Dow Theorists argue that, per Hamilton’s original indications, a move under the first step isn’t “significant” unless it lasts at least three weeks and corrects at least one-third of its previous move. On this interpretation, the market hasn’t come close to that first step.

To be sure, Jack Schannep, editor of TheDowTheory.com and one of the Dow Theorists I track, believes that in today’s fast-paced market environment, a smaller and shorter move can still count as “significant.” Under his version of the Theory, he told me in an email earlier this week, even a 3% pullback over a 10-day period qualifies.

Notice carefully, however, that even using Schannep’s more sensitive triggers, the stock market still hasn’t satisfied Step No. 1 of the three-step sell signal process, since only the Dow Transports satisfy.

Read: ‘Bull market check list remains intact’ despite pullback, Morgan Stanley says

Meanwhile, another core principle of the Dow Theory becomes particularly relevant: It holds that the previous signal is assumed to remain in force until it is reversed. And, since that previous signal was a buy signal, we should assume the bull market is still alive.

The more significant question investors should be asking: Why are many investors so eager to declare that the Aug. 7 high was the bull market top? From a contrarian point of view, of course, their obsession is a positive omen, since the hallmark of a major top is a denial that a top is imminent.

That’s not what we’re seeing today.

In fact, my own measures of market sentiment are also showing a healthy level of skepticism among stock-market timers about the bull’s health. While there are no guarantees, that increases the likelihood that the bull market’s final high is still ahead of us.

Now read: Here’s the shocking truth about the Russell 2000’s P/E ratio

For more information, including descriptions of the Hulbert Sentiment Indices, go to The Hulbert Financial Digest or email mark@hulbertratings.com.

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