Dow Theory Breakdown & Bear Market Indicators
On Monday, the S&P 500 and Dow Jones Industrial Average made history when they closed at all-time highs for the first time in more than a year.
Many investors are now expecting a modest rally to ensue, as Brexit worries fade away.
But this is not a time to be greedy and jump into a buying frenzy.
As I’ll show you in a minute, a more than a century old tried-and-tested theory is signaling an imminent collapse.
I’m talking about the Dow Theory…
In a broad sense, Dow Theory covers many market assumptions that exist today. But the part I am discussing today is in regard to the prediction of bull and bear markets.
In short, the theory suggests that when the Dow Jones Industrial Average and Dow Jones Transportation Average are both making higher highs and higher lows, broad markets are in a bull market. When those averages are making lower highs and lower lows, we are in a bear market.
The theory has held true over time.
But the key is that both have to conform to the trend.
Ultimately, we are looking for diversions between the two. In other words, one index making lower lows and lower highs while the other has not yet done so is an early warning of a possible shift from a bull market to a bear market.
We saw this in 2007, just before the global financial crisis, and we are seeing it play out again right now.
If 2007 offers a warning sign, now is a great time to take profits and prepare for the coming collapse.
Dow Theory Breakdown
Below are two charts — one representing 2007 and one from this past year. In each chart, the Dow Jones Industrial Average is the solid black line, while the Dow Jones Transportation Average is the solid red line.
Let’s break down 2007, then I’ll focus on 2016 so you can see the resemblances.
You can see at the first circle that the transportation average is creating slightly lower lows, while the industrial average has higher lows. This point marks a divergence from the trend, but it’s still too early to call a crash.
At the second circle, we have higher highs for the industrial average, but lower highs for the transportation average. The two are still opposite of each other and not yet conforming to a crash reading.
At circle three, we see both averages fall to lower lows, signaling a partial confirmation. But at circle four we see a rally, sending the transportation average to all-time highs. The key thing here at point four is that the industrial average has finally confirmed the bear market by setting lower highs.
From June 5, 2007, to the end of the year, both averages lost roughly 30% of their value in less than six months.
Dow Theory held true. It just takes time for the trends to become clear — hindsight is always 20/20.
These divergences from the trend in 2007 marked the first such occurrences since the 2001 dot-com bubble, and we’re seeing them again in 2016.
In the first circle, we see that the Dow Jones Industrial Average is setting a lower low alongside the transportation average. At the second circle, we see lower highs for both.
At this point, I was convinced a bear market was in full effect. I recommended grabbing put options and launched Pure Income as a means to collect income in any market environment.
At circle three, the industrial average failed to make clear lower lows, sending it back to higher highs today … circle four. Remember, we are watching for divergences between the two averages as an early warning signal of a new bear market.
The fact that the transportation average failed to partake in the recent rally after both made lower highs and lower lows tells me the negative investment sentiment is still here, and this is likely the last push higher for the Dow.
That’s why I’m using this recent rally as an opportunity to prepare for the coming bear market.
Preparing for the Bear Market Crash
Like in 2007, the averages are already signaling a bear market, with the transportation average making lower lows and lower highs. The industrial average will likely play catch-up for the rest of this year.
Dow Theory itself says that either average can lead the other — they just both have to eventually conform to either a bull or bear market. Right now, we are in the transition stage from one to the next, and it’s not always a clean-cut transition, as we saw in 2007 when the transportation average made one last run to higher highs.
The only safe bets to place … are bearish ones.
Until we see higher highs and higher lows from both averages, you have to position yourself to protect against a bear market. Keep in mind bear markets tend to not last too long. The one in 2008 crashed in September and October, bottoming just five months later.
So once you capture modest gains from a sharp bear-market move, take profits and wait for stocks to form a bottom. Then you can begin looking to pick up many of the stocks you took profits on at far cheaper prices.
Editor, Pure Income