US stockmarkets are now officially in correction' territory, having fallen by more than 10% from their October highs.
But they could be set to fall even further if one of the most reliable signals used by chartists (who invest by focusing on patterns in markets and share prices, rather than fundamentals) is correct.
According to Dow Theory, Wednesday 21 November marked the start of a long-term bear market in the US. The theory is one of the oldest systems in the history of charting today's best-known exponent, Richard Russell, has been writing his Dow Theory Letters for about 50 years. But its origins date back to the 19th century and the ideas of Charles Dow, then editor of The Wall Street Journal.
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Mapping greed and fear
Underpinning the theory is the idea that humans act in herds. Unchanged for thousands of years, their basic investing emotions usually a mixture of greed and fear are captured perfectly in the ebb and flow of stockmarkets. These mood swings can be read and predicted from charts.
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The broad market indices (FTSE, S&P, Dow Jones) thought best to reflect mass investor psychology may seem to lurch up and down in myriad tiny zig-zags, but in fact they display clear "primary movements" (bull and bear phases), say the Dow Theorists. These can often last for years and are punctuated by far less significant "secondary movements" that may temporarily buck the big trends, but don't negate them.
The trick is to identify the sea changes like this month's primary move from bull to bear phase and not get wrong footed by smaller, inconsequential ones. Dow Theorists believe that the best indicators of the future direction of US stock prices boil down to just two: the Dow Jones Industrial Average (DJIA) and the Dow Jones Transportation Average (DJTA).
The importance of transport
The DJIA, made up of the top 30 stocks in the US, has been a solid barometer of America's economic health for over a century. But Dow Theory believers back it up with the DJTA, an index of 20 transport stocks, which gives a good idea of the strength of demand for bulk transport, whether by road, rail or air.
This is because, in anticipation of an upturn, industrial firms will order more raw materials and generate higher profits. These materials are delivered by transport firms, boosting their profits and share prices, and pushing up the DJTA index.
The reverse is true in a downturn. As DJIA firms lose sales and cut stock (in anticipation of falling demand), their profits and share prices suffer, which in turn hits the DJTA.
Their fortunes remain entwined even today, until "Amazon.com learns how to send plasma TVs via cable modem", as analyst Paul Shread puts it on Internetnews.com. It's a simple enough concept and also one of the more successful.
A joint study by New York and Yale University claimed that Dow Theory stock-trading systems outperformed buy and hold strategies by 2% a year over a 60-year period. In fact, Martin Pring's "Technical analysis explained" claims that the theory has correctly predicted sell signals 80% of the time in its long history.
So what's happening now?
All Dow Theorists share the view that the DJIA and DJTA averages must confirm each other before you get a bull or bear trend. Inevitably there is disagreement amongst bulls and bears about when this has occurred, but most (Richard Russell included) now say we are in a primary bear phase, rather than a secondary dip in a bull market. Here's why.
Back in July, all looked well in the US as both indices moved to all-time highs. However, the credit crunch then struck, sending both sharply lower by the middle of August.
So far, so even, but what has happened since is the bad news. While the DJIA recovered to set a new high of 14,164 on 9 October, this was not supported by an equal rise in the DJTA. In Dow jargon, the DJTA failed to confirm' the move up in the DJIA.
By 19 November, the DJTA had fallen further, to its lowest level since October 2006, while on 21 November the DJIA breached its August low of 12,846 to close at 12,799.
In other words, the DJIA confirmed the fall in the DJTA, signalling a change in the primary trend, and resulting in the first official sell' signal since June 2003, according to Shread. Given all the other problems the market is facing, this is one bad omen we won't be betting against.
