Identify the Primary Market Trend using The Dow Theory

The correct determination of the direction of the primary trend is the most important factor in successful speculation (trading and investing). The primary trend (also referred to as movement) is the broad basic trend generally known as a bull or bear market lasting a period of time from less than a year to several years. The primary trend is the most important of the three movements discussed within The Dow Theory.

The Dow Theory also includes movements such as the secondary reaction and the daily fluctuations. I am not interested in daily action because these short term movements are typically unimportant.

Edwards and Magee said:

“The Dow Theory is the granddaddy of all technical market studies” and “It is built upon and concerned with nothing but the action of the stock market itself (as expressed in certain “averages”), deriving nothing from the business statistics on which the fundamentalists depend”

The purpose of this post is to highlight the Principle of Confirmation which states that The Two Averages Must Confirm. The authors note that this principle has often been questioned and is the most difficult to rationalize of all the principles yet it has stood the test of time.

They go on to say:

“the fact that it has “worked” is not disputed by any who have carefully examined the records. Those who have disregarded it in practice have, more often than not, had occasion to regret their apostasy”.

Please repeat the following rule several times and learn it, understand it and trade by it:

“What it means is that NO valid signal of a change in trend can be produced by the action of one average alone”.

Here is a chart from the 4th edition of their book Technical Analysis of Stock Trends, published in 1957

Now take a look at today’s Dow Jones and Transports. Do you see any similarities?

Of course you do, the Transports have not confirmed the change in trend along with the DOW. In fact, the $DJIA is now back below the resistance line after this week’s negative action.

Many traders on StockTwits, Twitter, blogs and TV (if you still watch financial television) are miffed about the action of the market over the past several weeks, particularly the past week. Well, the trend hasn’t confirmed so the risk is still high that the so-called “leaders” are setting up for failure or head-fakes.

I’ve started to sound like a broken record with my Dow Theory tweets but if it is fact, it is fact. As traders, we must be patient and wait for the confirmation before loading up on new shares. A trend change may still occur but we must cast a shadow of doubt until both averages confirm.

If you don’t want to listen to me, a lowly stock blogger, at least listen to what Robert Rhea said in 1932:

“The movement of both the railroad and industrial stock averages should always be considered together. The movement of one price average must be confirmed by the other before reliable inferences may be drawn. Conclusions based upon the movement of one average, unconfirmed by the other, are almost certain to prove misleading.”

Please note that “railroads” have been replaced with “transports” in today’s world.

Trading can essentially be broken down to managing risk and as Victor Sperandeo stated, “market forecasting is a matter of probabilities; the risk of being wrong is always present”.

So why tilt the risk against you if history shows us that both averages must confirm for a sustainable change of trend to take place. It’s a wacky world out there but the rules haven’t changed so wait for the confirmation before jumping in with both feet.

Market observation from Thursday, November 17, 2011: The NASDAQ has now flashed four distribution days since the start of the month. This is a red flag and a signal to lock in profits and sell losing positions before they grow in size.

Continue to follow me on twitter for daily tweets, charts and links to great articles.

Market Overview: Identifying a Change of Trend

Standard & Poor’s said it downgraded the U.S. government’s credit rating from AAA to AA+ because it believes the U.S. will keep having problems getting its finances under control and pointed to the lack of leadership in Washington. Per Yahoo Finance: “The Obama administration called the move a hasty decision based on wrong calculations about the federal budget. It had tried to head off the downgrade before it was announced late Friday.”

Politicians lie and markets do not so ignore Washington and focus on PRICE and VOLUME action!

So, with that said, what does last week’s action across the US and global market truly mean? The $DJIA was down 5.75% on the largest volume since last summer, the $COMPQ was down 8.13% on the largest volume since May 2010 and the $SPX was down 7.19% on the largest volume since May 2010.

All three major markets confirmed a Dow Theory Reversal, a “Change of Trend”. In addition to the major indexes, the Dow Transports TRAN also confirmed a Dow Theory Reversal by breaking support and making a lower low.

Emotionally, I suspect that the market will bounce and that many stocks and indexes are “oversold” but this will most likely only be short term. Long term, the trend HAS CHANGED according to the charts. And until the charts show a new trend to the upside, all moves up are suspect. No one has to pick the exact bottom or top of a market so be grateful to recognize a trend and grab 60-80% of the move. It’s a lot safer and less risky to jump on board once the trend is confirmed rather than play a guessing game that can get you caught in a 500 point slide, similar to last Thursday. Markets can change on a dime so be prepared at all times but longer term trends stay intact for months, if not years.

I made a mistake in my general market analysis by not paying enough attention to my New High – New Low (NH/NL) Indicator. And it cost me because I put on positions in $RENN and $DANG in recent weeks after warning signals had been given. I did avoid a new position in $LNKD and saved money heading into the earnings announcement. Overall, shame on me but I didn’t lose too much because rules were followed and I am digging deep to listen to my indicators. Regardless of what “ I think may happen”, I am listening to my indicators and charts 100%!

So you ask: What warning signals?
The first signal was given by the Dow Jones NH/NL 10-day average differential (Diff) (chart above). The 10-d Diff started to make lower lows as the Dow was making higher highs, a clear divergence that warns the underlying stocks are weakening while the overall market is making a new high. This one signal alone should have put me on caution while entering new positions. It didn’t because the NH/NL 10-d Diff was still above the critical level of zero. Well, the market took care of that this week by plunging below the zero level, closing at -203 on Friday for the Dow. Consider this, it closed at +15.1 last Thursday ( 7/28) but went red the following day at -2.5 (last Friday, July 29, 2011). The divergence and the reading below zero was now screaming MOVE TO CASH and gave us enough time to do it before the end of the week romp! We all had time to get out without taking a loss. As it stands now, the 30-d Diff is also below zero with a reading of -21.47, the first reading below zero since July of 2010.

It’s interesting that the markets topped in May, just as Osama Bin Laden was killed – I must give a HT to Howard Lindzon for coining the Osama Bin Laden Top (he may have nailed it) and closing his blog post with this statement:

With the mood of financial markets quickly turning negative, the horrific price action of financials, the silliness of IPO valuations and some Bitcoin mishigas, you may not soon forget the ‘Osama’ top.

Now, let’s take a look at a number of charts and see what they “were” saying and what they “are” saying right now, as we head into next week (ahead of the market reaction to the US credit downgrade). NOTE: I personally believe that the downgrade is mostly priced into the market but I am sure we will still see some further selling pressure before a normal bounce.

[Read more…]

Cup with Handle or 1-2-3 Reversal

As September nears, we should all be asking the question:

Is the market headed for a reversal or an “up” trend continuation?

I don’t know nor does anyone else but what we can do is sit tight and get ready to trade the confirmation, whether it is up or down. A break of support is a signal to begin shorting the market. A move above resistance will be a signal to buy breakouts.

It’s that simple. See below for the three major indexes and their current support and resistant levels:

Trend Reversal Coming…?

Will the Nasdaq, Dow Jones Industrial and S&P (SPDR’s) confirm the 1-2-3 Trend Reversal like Blackrock has?

Time will tell, give it another 1-3 months to confirm (September may be the time but I can’t tell you for sure). Wait for the confirmation before taking the short trade. A move above the “blue” line breaks the pattern setup!

I can tell you this: The trend has been challenged, the minor low has been established and now we are looking to work on “point #2″. A failure to recover the blue line will establish point #2. A violation of the horizontal red line will confirm point #3 and trigger the short play: TREND REVERSAL CONFIRMATION.

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1-2-3 Trend Reversal Watch

Traders must have patience as “we” look to capitalize on the 1-2-3 pattern. Using the chart samples below (real time 1-2-3 pattern confirmations), we can see that the typical setup takes anywhere from 4-6 months to confirm. Continue to follow me on Twitter as I will be highlighting the dozens of potential candidates over the next several weeks.

I can’t say that all or even if many will confirm but if the major indices confirm the pattern, it will be like taking candy from a baby on the short side. As you may know, nearly 75% of the stocks in the market follow or move in the same direction as the overall indices.

This could get fun. I am currently looking for a short term bounce in the general market and the stocks on my “short” watch list (point #2 confirmation). After point #2 forms, we then start to load up (on the action watch list) and look to short upon confirmation.

Recent posts reviewing the 1-2-3 Pattern:

Two sample stocks confirming the 1-2-3 pattern and two starting to confirm the pattern: MSTR, PKX, ADBE and TECD

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Notable stocks with the 1-2-3 pattern potentially forming:
MA, V, GOOG

Stocks with their 10-week moving average crossing below their 30-week moving average (this week):
NBL, JNJ, AGU, BBL, HPQ, SNN, UNF, MAN, ACN, HMC, MR, MEE, DWA, PEGA, ASML, CE, MSFT