Dow Theory Says Market Correction Is Over

01/15/09 09:50:05 AM

by Alan R. Northam

The corrective rally for the Dow Jones Industrial Average (DJIA) is now over and a new downward trend is being established. However, this new downward trend remains unconfirmed but will be, once the Dow theory has been satisfied.

Security: $INDU
Position: N/A

Charles Henry Dow defined an upward trend as a series of waves forming higher highs and higher lows and a downward trend as a series of waves forming lower highs and lower lows. A change of trend occurs when a series of higher highs and higher lows is broken or a series of lower highs and lower lows is broken. These definitions of an upward trend and a downward trend later became part of what is now known as Dow theory.

Figure 1 shows shows the daily price chart of the DJIA. In November 2008, the DJIA entered into a corrective rally. Since then, the DJIA has formed a series of higher highs (marked HH on the chart) and higher lows (marked HL). Today, the DJIA broke below and closed below the HL formed on December 12, 2008. This breakdown formed the first lower low since the corrective rally began, thus breaking the series of higher highs and higher lows. This breakdown signals that the corrective rally has come to an end.

FIGURE 1: DJIA, DAILY. This chart also shows the daily volume bars below the price chart and the RSI.

Graphic provided by: StockCharts.com.

According to Dow theory, the DJIA must now make a lower high followed by a lower low to establish itself in a new downward trend. I have plotted what I believe to be the highest probability course of action for the DJIA to follow on the price chart in Figure 1. I have the DJIA now testing the support zone. I expect the DJIA to move into this support zone but reverse direction inside the support zone to complete the formation of the lower low that is being formed by the breakdown below the December 12th higher low (marked HL on the chart). The reason for this expectation is the current selling momentum that is in force (see relative strength index [RSI] below the price chart in Figure 1). I then expect the DJIA to rally in an attempt to recover from its early January 2009 losses by moving higher, but the rally will most likely fail somewhere around the 50-62% retracement of the sell starting in early January. Once this rally attempt fails, the DJIA should turn back down to resume the selloff to form a new lower low. The formation of this lower low will then satisfy the Dow theory that a new downward trend has been established.

Looking at the volume bars below the price chart, note that over the last three trading sessions, volume has been drastically increasing. This increase in volume represents an increase in selling force that lead to the ending of the corrective rally. This selling force should also cause the DJIA to break into the support zone that the DJIA is now testing. If selling volume continues to increase while the DJIA is moving through this support zone, then the DJIA could break down below the support zone. But if selling volume starts to contract, then expect the DJIA to reverse to the upside somewhere within the support zone.

I have also shown the RSI below the price chart and the volume chart. The RSI is a measure of the average daily gains over the last 13 days divided by the average of the daily losses. If the result of this ratio is greater than 50%, it signals that there is a net gain over the last 13 trading sessions, indicating that the market is moving upward. A ratio of less than 50% signals a net loss over the last 13 trading sessions and indicates that the market is moving lower. The RSI is currently reading 37.91%, indicating that the market is now moving in a downward direction. Thus, RSI is confirming the breakdown on the price chart.

In conclusion, the corrective rally that began in late November 2008 has come to an end and a new downward trend is being established. This new downward trend is confirmed by the RSI that shows over the last 13 trading sessions the market has yielded a net loss. Although the corrective rally has ended and the DJIA is now moving lower, the establishment of a new downward trend remains unconfirmed. This new downward trend will be confirmed once Dow theory is satisfied by the DJIA forming a new lower high followed by a new lower low: such a course of action is plotted on the price chart.

Alan R. Northam

Alan Northam lives in the Dallas, Texas area and as an electronic engineer gave him an analytical mind from which he has developed a thorough knowledge of stock market technical analysis. His abilities to analyze the future direction of the stock market has allowed him to successfully trade of his own portfolio over the last 30 years. Mr. Northam is now retired and trading the stock market full time. You can reach him at inquiry@tradersclassroom.com or by visiting his website at http://www.tradersclassroom.com. You can also follow him on Twitter @TradersClassrm.