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This column was originally published on RealMoney on July 17 at 10:30 a.m. EDT. It's being republished as a bonus for TheStreet.com readers.
Very early in my trading career, I studied the Dow Theory developed by Charles Dow. As much as anything else, it helped me make sense of the market because it is a combination of technical analysis and market philosophy. It put the pictures I was seeing into a real world context that explained them.
The Dow Theory can be used to identify broad market trends in the
Dow Jones Industrial Average and Dow Jones Transportation Average. In very simple terms, an uptrend in the market is confirmed when both averages are making higher highs. A downtrend is marked by lower lows in both.
The industrial and transportation averages are extremely useful in signaling trend reversals because of their broad representation across the economic spectrum.
In simple terms, the industrial average consists of companies that make stuff; the transportation average consists of companies that move that stuff to market. You can see how it pays to keep track of them.
A downturn in the industrial average isn't confirmed until we see a downturn of the transportation average. Only when both averages have gone from higher highs and lows to lower highs and lows do we consider a downtrend to be in effect.
Let's see what these indices have been up to.
Looking at a weekly line chart helps clear out some of the needless noise of my usual candlestick charts.
I've drawn a series of circles to mark the highs and lows of the Dow Industrials. Numbers 1 through 5 show a series of higher highs and lows leading up to the May high. Since then, the industrials have begun making a series of lower highs and lows.
Notice how the previous low at No. 4 (around 11,100) became a resistance level marked by No. 7 last month. That's a lower high in my book. Last week's decline pushed the index below No. 6, setting up a lower low.
Is this confirmed by a similar pattern in the Transport Index?
I can use a candlestick chart for the transports because they have been in a clearly defined trend. From the 2004 low, the transports advanced more than 81% to its 2006 high. In that same period, the industrials rose just 18% before peaking. Simply put, the companies that make stuff have been struggling, while the companies that move that stuff have been doing well.
However, a decline below 4,500 would establish a lower low for the transports, confirming the reversal in the Industrial Average. If that happens, you'll probably hear more people talking about the Dow Theory.
Let's look at a few reader picks.
Cummins(CMI - Get Report) is in a strong uptrend on a weekly chart, but the series of lower lows and higher highs is a bit troubling. We typically see this type of formation at tops, as more and more uncertainty and emotion make their way into the price movement. The recent heavy volume is also consistent with a top.
If you've been waiting to buy
BTU International(BTUI), now is your chance after a sharp retracement to prior support at $12. Any long positions can be protected with a pretty tight stop.
Middleby Corp.(MIDD - Get Report) is in a series of lower highs and lower lows. The stock is at the bottom of its descending channel, so I don't think it's in a very actionable spot now. It is poised to move higher on a snapback of the recent decline, but I believe the higher percentage trade is to wait for the stock to test resistance before selling.
Be careful out there.
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Here's your chance to pick the stock you'd like me to feature on my radio show July 20:
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