This time of year everyone is working hard on predicting what to expect in 2016. While no one knows for certain what will happen in 2016, one thing is for certain, it will be a year full of surprises.
Investors use all types of techniques to make longer term stock market projections. One of these techniques is truly the cornerstone of all longer term technical analysis.
This method is called Dow Theory.
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Let’s take a closer look at Dow Theory and then see what it is saying about what may happen in 2016.
Dow Theory is a tool to determine the actual trend of the stock market. Be that trend bullish or bearish.
Just for clarification, market trend means the overall directional movement, as shown on price charts, as either up or down.
Uptrends are well-defined as a series of higher highs and higher lows.
Downtrends are a series lower highs and lower lows.
Classical technical analysis imparts that trends are useable until a change of trend is proven to have taken place. Dow Theory refines the concept of trend by breaking it into three distinct movements:
- The Primary Movement
This is the long-term trend. The Primary Movement can last from a few months to multiple years. It can be an uptrend or a downtrend, however according to Dow theorist, William Hamilton, it’s impossible to forecast either the strength or length of the Primary Movement. Hamilton believed that success in the market was keyed into the ability to identify the Primary Movement, invest/trade in its direction, and stick with the trade until proven wrong. This struck me as being uncannily similar to the modern day “Trend Followers.”
- The Secondary Movement
This is what is known as a pull back or retracement in a bull market. In bear markets, it’s called a reactionary rally or bounce.
This movement can last from 10 days to several months and retraces the Primary Movement by an average of 50%.
It’s important to note that these changes tend to be sharper and more severe than the Primary Movement. This shakes out many of the weaker longs or shorts who were correctly riding the Primary Movement.
- The Short Swing or Minor Movement
If you are a day trader or short term swing trader, this is the price movement that you trade. It can last from intraday to several days but does not convert into a Secondary Movement until two weeks.
Dow Theory teaches that there are 3 phases within every major market trend. In a bull trend, these stages are:
- The Accumulation Phase
Dow Theory trusts that this is the time where the big money, insiders are quietly buying shares against the general opinion of the public. They are using their inside knowledge of what may happen to buy stock at what looks like a poor time to buy to the general public. This enables these insiders to accumulate shares without affecting the market much, as the public is readily selling to them.
- The Big Move—
This moves occurs when the market has already started to trend higher. Technical traders begin to buy as their technical indicators start to generate buy signals. The trend followers also catch on during this phase, pushing the market even higher.
- Public Participation/Excess
This is the final phase of the bull market. Widespread public participation in the market is what signals this phase. Everyone from the shoeshine boy to the CEO are stock investors. You start getting stock tips from everyone and cocktail chatter is focused on the market. Astute investors know that the top is very close when signs of this market phase begin to surface.
The opposite of a bull market is a bear market. Here are the market phases to look for during bear markets.
Distribution is the opposite of the accumulation phase in a bull market.
It happens when the smart/big money begins to reason that the bull market is over, although the public still trusts the uptrend will never finish.
They begin to dump shares to the public who joyfully buys all that can be thrown at them, oblivious to the obvious fact that the market is topping.
The market will start to go down, but most analysts and traders will refuse to believe the bull trend is over. This strong belief in the longevity of the bull trend will cause new money to come into the market during these times, sometimes a lot of it.
This new influx will result in sharp, severe rallies that will bring in even more capital into the market as it seems that the bull trend has resumed. This move will not take out the previous highs and is merely a reactionary rally, then phase 2 starts
A good way to think about this phase is the stock market pulling in all the money it can before it plunges, causing big losses from naïve investors.
- The Big Down Move
The severe selling starts after the reactionary rally nose-dives.
The investment community starts to get worried and begins to sell stocks, pushing the market down even faster.
Bad news begins to sweep the news wires, what was once a rosy picture begins to be filled with negativity and despair, leading us to the next and final phase of the bear trend.
Despair is when the public gives up on the stock market. You no longer hear market chatter on the street and hot tips are strangely absent from your E mail inbox, around the office water cooler, and Cocktail lounge.
Once people start to believe that the market will stay down forever, a new uptrend will begin and the whole cycle starts again.
How To Use It
The next primary concept in Dow Theory is that 2 Averages must confirm the trend together.
Prior to the Transportation index, Charles Dow used the Railroad Index to confirm the trend in the DJIA.
Today, Dow theorists use the Transportation Index to confirm the trend in the DJIA.
The theory behind this confirmation is that the United States is connected via the transportation sector or rail sector in Mr. Dow’s day, therefore the transportation index should reflect booming or busting economic times.
If one of these averages makes a new high or low, the other one needs to confirm soon after for a Dow Theory buy/sell signal to be valid.
The Importance of Volume
Volume is the final aspect of Dow theory. Charles Hamilton believed that volume is necessary, but the price has the last word in trend determination. His idea was that volume should increase in the direction of the primary trend and decrease on corrections. Dow theory teaches that volume is a way to judge the strength of a trend, not the direction. However, extremely high volume relative volume readings can signal a reversal. Technical Analysts refer to these occurrences as “blow off tops”.
What Does Dow Theory Tell Us About 2016?
Now that we have a rudimentary understanding of Dow Theory, just what is it telling us about 2016?
The first thing to identify is that we are still in a bull market. There was a pull back into almost bear market territory from August through October.
In my opinion, this pull back fits the “secondary movement” of the bull market. Today, the DJIA has bounced back to within 500 points of the all-time highs.
With the current volatility, 500 points can easily be taken out in several or even one trading session!
Clearly, if the upward trend continues, all-time highs can be expected in 2016 once again.
However, an ominous signal is emerging in the transportation index. On the weekly chart, there is a divergence between the DJIA and the transportation index. The transportation index is not confirming the current strength in the DJIA.
I do not believe the divergence is sharp enough to be a true bearish signal currently. At the same time, it is important to keep it in mind should it become more severe.
2016 will be bullish!!