The Dow Jones

The Smart Profits Report: Issue #334
Monday, July 24, 2006

The Dow Jones: Technical Charting Shows Trouble On the Horizon
By Jim Stanton
Advisory Panelist, Mt. Vernon Research

In the aftermath of a crushing bear market, it’s nearly always the small caps that emerge from the wreckage in the best shape. On the other hand, the so-called “big boys,” like the Dow Jones, have not fared so well.

The story is no different this time around. Since the end of the 2000-2002 bear market, which ended in October 2002, the smaller-cap indexes such as the Russell 2000, S&P 600 and S&P 400 (mid-cap) have performed best and rallied past the peak of the dotcom craze of March 2000. Along with the Dow Transportation and Utility indexes, all have gone on to record new highs. The Dow Jones, S&P 500 and Nasdaq Composite indexes have yet to achieve those heady heights.

Yes, all three have traded in a long-term uptrend since the bear market lows. But the Nasdaq has only been able to recoup 30% of its losses, while the S&P 500 has clawed back 70%. The first 10 days or so of May seemed to be the key period, with the Dow Jones inching within 80 points of its all-time high, but then stumbling off the cliff. The old adage, “Sell in May, then go away” is certainly on the money this year.

With many investors exasperated, the big question now is: “When will the selling end?” Fortunately, the technical charts provide some clues…

Selling to Continue, Despite Fed Hype

Since mid-May, the indexes have engaged in a furious battle between bulls and bears. Except for a mini counter-trend rally at the end of May, they spent most of their time spiraling downwards until June 14. At that point, the signals pointed to a market that was extremely oversold and the bulls inched back into the water. But they’d only recouped about half their losses before they got scared again and the bears took over.

Since then, all the indexes, except for the S&P 500, have traded below their June lows, with the Nasdaq looking particularly poor.

As the Dow Industrials hit their 2006 low last week, Federal Reserve Chairman Ben Bernanke donned his rose-tinted glasses and basically told the market not to worry about current economic conditions, higher inflation and a slowing real estate market. He instead reminded Americans to focus on the future - one in which the “resilient economy” would chalk up annual GDP growth of 3%, with inflation tame.

In response, the markets promptly enjoyed one of their best days of the year, with the S&P 500 rallying more than 22 points on heavy volume and great market breadth. For a while, many traders giddily believed this had stopped the bleeding.

Not me. We only saw the hedge funds engaging in a mass short covering rally - one that ran out of steam by the end of the day. The markets then sold off again over the next two days, with all three small-cap indexes (mentioned earlier) making new correction lows, along with the Dow Transports. The Nasdaq indexes came within a few points of doing the same.

This action tells us that the institutions are using these counter-trend rallies as selling opportunities. This is not bullish and the correction has further to go. But how much further?

Looking to the Dow Jones for Long-Term Answers

Given that the Dow Jones has performed the best of the three major indexes since October 2000, let’s take a technical approach to it to hunt for clues as to where the markets might be headed over the intermediate term.

“Dow Theory” is the basis for modern technical analysis and a concept actually credited to William Hamilton, the understudy of Dow Jones Industrial Average founder Charles Dow. In order for a bull market to continue, according to the theory, the Industrials and Transports have to move in unison and make higher highs together. Usually, this needs to occur within a week or so, and if it doesn’t, the markets are set up for a downturn.

The same is true in a bear market. If one makes new lows and the other one does not, it sets up a potential buy signal.

On May 12, the Dow Transports traded over 5,000 and made an all-time high. But the DJIA fell 80 points short of its all-time high. This is known as “Dow Theory divergence” - and true to the theory, you know what’s occurred since then.

The Dow Industrials made new correction lows on July 18 and the Dow Transports followed suit, making new correction lows on July 21.

According to Dow Theory, since they are moving in unison, they will remain under a sell signal until we see a Dow Theory divergence. And my proprietary trading model also signals lower prices over the intermediate-term, so we’ll take a look at a daily chart of the Dow Industrials to see how far down it could go.

Daily Chart of the Dow Jones: How Low Can It Go?
Chart Courtesy of Trade Navigator Software

Two Dow Scenarios That Call for a “Put Plan”

As you can see, the Dow Jones made a slightly lower low in July, but has rebounded since then. This opens up two potential scenarios:

The Dow could remain in the 10,700-11,260 trading range - and possibly approach the upper end of that range in order to work off the oversold conditions before coming back down.
The selloff continues, with the Dow sinking down to the 10,490 level. According to my trading model, this is its minimum downside target.

Bottom line: Since the Dow Transports and the small-cap indexes all made new correction lows after Ben Bernanke’s comments last Wednesday, the odds favor a continuation of the selloff from current levels.

If this doesn’t happen and the DJIA attempts to rally back up near the top of its trading range, I will be adding to my portfolio of put positions - and you should, too.

Good Trading,

Jim Stanton

Today’s Smart Profits Cribsheet

There’s no doubt about it: This is one of the most volatile periods for the stock markets in recent memory. Don’t let your portfolio get crushed with everyone else’s. Protect yourself today, using our simple guidelines. For details, check out Smart Profits #326: Stock Market Volatility: Three Ways to Combat Volatility’s “Radical Shift”

Investor sentiment and market behavior is notoriously unpredictable - especially when the markets face the many turbulent external factors you see today. But there’s no reason why you should be caught out. Follow the Smart Profits #311, Investor Sentiment & Market Behavior: A 7-Step Plan for Developing a Profitable Downside Bias and find out how you can make money, even when others are losing theirs.

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