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Dow Jones Industrial Average
The Smart Profits Report: Issue #365
Wednesday, October 25, 2006
Dow Jones Industrial Average: Don’t Be Fooled By The Dow’s New Highs & Beware The Pullback Signs
By D.R. Barton, Jr.
Quantitative Analyst, Mt. Vernon Research
The Dow Jones Industrial Average just keeps making new highs. In fact, it’s made a new all-time high on 11 of the last 16 trading days.
The Dow is the most watched stock index in the world. It’s so popular it acts as the benchmark for the overall market (as in, “What’s the Dow doing today?”) And the fact that it’s making a string of new record highs is significant.
But right now might not be the time to get caught up in the bullish fever.
That’s because while the Dow Jones and the other broader market indexes push higher, there are ominous signs that point to a pullback in the markets - and sooner rather than later.
How Are The Pros Playing The Markets?
One set of data that I like to use is sentiment analysis. I’ve written about it many times before. But as a brief refresher, sentiment analysis seeks to quantify and qualify investor sentiment to gain an understanding of what the market is likely to do next. There are many tools used for sentiment analysis - including:
- Put/call ratios
- Volatility measures
- Asset flows
- Sentiment surveys
One sentiment tool I like is the Commitments of Traders Report. This comes from the Commodities Futures Trading Commission (CFTC), which collects data from all traders who trade in “reportable size” (a size above a threshold set by the CFTC).
This data can prove quite useful, especially since the CFTC separates the data into three categories: Large Speculators, Commercial Traders (those who use futures contracts in their day-to-day activity, and may have the best read of current market conditions) and Small Speculators (mainly retail traders).
So what’s the big story here?
Commercial traders are holding their largest short position in the S&P of the past 22 months! Check it out on the chart below:
This research by Bennet Sedacca of Atlantic Advisors, LLC (and reported by analyst Tom Peterson) also shows an interesting correlation of up and down moves during times when the commercial traders held extreme positions.
But that’s just one early warning flag for us. Here’s another…
Charles Dow Himself Warned About This Market Condition
Charles Dow is widely regarded as the father of technical analysis. One of the tenets of his “Dow Theory” is that when the Dow Industrial Average and the Transportation Average are at odds, the market is unstable (for more information on Dow Theory, and how it works, check out today’s “Cribsheet” below).
And that’s exactly what’s happening today. Take a look at the chart below, and you’ll see that the Transports haven’t been as excited as their Industrial brethren about these new highs. This type of divergence usually leads to a correction (kudos to my good friend Christopher Castroviejo for pointing out the divergence in this venerable relationship).
Your Next Move?
I don’t think it’s time to jump ship just yet on this recent bullish run. There’s a good chance we could get a “blow-off top” before this is over.
But I do think we’re getting clear indications that a pullback is due in the near future. But if you don’t want to look at the short side and you’re not fully invested, don’t jump in when the market is at its most frothy unless you have a strategy. To short this market, I think you need a clear sign that we’ve started to pull back (basically a couple of weak sessions on the Dow Jones Industrial Average). So wait for the expected pullback to give you better entry prices.
Good Trading,
D.R. Barton, Jr.
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Today’s Smart Profits Cribsheet
- My colleague and top technical analyst, Jim Stanton, has written in detail about Dow Theory, and the relationship between the Dow Jones Industrials and Dow Transportation Index in this column before. So for more information on this interesting and pretty reliable relationship, check out Smart Profits #362: Dow Theory: The Most Important And Powerful Concept In Technical Analysis.
- In the above article D.R. Barton Jr, uses sentiment analysis to watch sizable commodities futures trades that set the moods for the markets. Check out the Smart Profits Glossary for definitions of other types of analysis used by technical traders or you can also check out the Smart Profits Site Map for other articles dealing with all things technical analysis.
Related Articles:
- The Stock Market’s Reaction to Good News: Why It’s Best to Sell at the Sound of the Trumpets
- The Dow Jones: Technical Charting Shows Trouble On the Horizon
- Defensive Covered Call Strategy: What’s Better Than Making Money? Keeping It
The Chart of the Week - Pat On The Back Edition
This chart shows the relationship between 100 shares of Archer-Daniels-Midland (NYSE: ADM) and a contract of corn futures. Back in August, I recommended shorting this ratio, because of the fervor over ethanol and how it was only being reflected in the distillers’ price, while the corn farmers were getting the short end of the stick. This ratio has dropped as predicted, bringing the relationship back into a more reasonable range.
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