Sell signal

The Dow Theory has given a sell-signal. This was almost inevitable given the strength of the sell-off last Wednesday, as I was writing last week’s column. The big drop on Wall Street saw the Dow Jones Industrials and the S&P 500 indices close below their previous correction lows, triggering the signal. The US market has therefore gone from being in a secondary reaction within a primary uptrend to being in a primary downtrend, in Dow-theory parlance.

Heavy selling in Dow

What does this mean for US stocks, and by extension, for our own market? For the answer to this, we can turn to Jack & Bart Schannep (www.thedowtheory.com), the contemporary successors to Charles Dow. They have done for his theory what Marc Rivalland has done for Gann’s swing-charts, adding better definition to the rules, and refining the signals to make them timelier, and hence potentially more profitable.

According to Jack & Bart, the average drop in the S&P 500 index following a Dow-theory sell-signal since 1953 has been 14.8 per cent over 6.2 months. On 15 out of 24 occasions, an official bear market followed. On 8 occasions, however, the losses that followed were less than 10 per cent. Personally, I envisage the latter scenario as the more likely at this stage. I am not turning significantly bearish at this stage.

Oversold Nasdaq

While I have been advocating short positions in my daily Outlook notes on our website, I also believe we could be nearing an important low before long. For a start, the US indices are now very close to being oversold, for the first time since their summer lows. The Dow and Nasdaq 100 have both registered oversold readings of 30 per cent on their daily relative strength indicators (RSIs). In themselves, such readings are not a reason to buy. But a strong bounce from oversold levels would be a good reason.

S&P breaks key line

In the summer, the moment to buy the S&P came just after it had closed below its 200-day moving average. The very lows of the move were not accompanied by a fresh low in the already-oversold daily RSI, a situation known as 'positive divergence.' A 2.3 per cent gain in a single session then provided the first meaningful clue that a powerful new uptrend was underway.

While the S&P is just shy of formally oversold levels (32 per cent vs 30 per cent), it has now closed firmly below its 200-day moving average. If it shortly becomes formally oversold, then registers positive divergence and finally bounces decisively for a session or two, I shall start seeking long positions once more. As things stand, therefore, I would not need to wait for the Dow-theory sell-signal to be reversed. An eventual buy-signal will merely act as confirmation for me.

Healthy scepticism

There is another similarity between today and the period around June’s lows. The mood of American pundits is getting as cautious as it was back then. In this week’s Investors’ Intelligence report, 38.3 per cent of tipsters were bullish, while 28.7 per cent were bearish, a gap of 9.6 points. That’s well down from the excessively rosy reading of 29.7 points at mid-September’s market highs, and strikingly close to the gap of 7.4 around June’s bottom.

I have just recorded an excellent interview with my friend and technical mentor Zak Mir on Monday that you’ll be able to watch on our site shortly. Like me, he reckons that the S&P and FTSE are due for some substantial upside before long, well above 1500 and 6000 respectively.

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