I love it. The market action in recent days is providing me with lots of real-time and real world examples to show my students at Baruch College in New York City. This semester I have 80 students who have open minds and want to learn about the "dark side" - a.k.a. technical analysis. Tonight I plan on finishing up our discussion of Dow Theory.
Exhale. No, we do not have a Dow Theory sell signal. We do not have a "non-confirmation" between the Industrials and the Transportation Averages either. When you drill down into the 30 well-known companies that make up the Dow Industrials you find pullbacks and not major top patterns. We have pointed this out in this column on a few Dow components that were looking vulnerable. Looking vulnerable does not make a top. Dow Theory, however, will miss the actual high as its signals are late by design.
One technical approach (probably invented by Gerald Appel) that may help in identifying tops and bottoms of intermediate-term moves is using Moving Average Envelopes. These envelopes are percentage bands above and below an important simple moving average line. Let's look at two charts of the S&P 500, below.
In this daily bar chart of the S&P 500, below, we can see how the index hit the upper band of the envelope last month and in a matter of days has traded down to the lower band. Prices can trade below (and above) the bands but typically this is not long sustained.
A daily chart represents shorter-term movements. A monthly bar chart, below, may only give us one or two signals in a year and could be used by position traders and/or investors.
In this chart, below, I use a 12-month moving average line and take 12.5% above and 12.5% below for the envelope. You can see that the S&P 500 Index bumped up against the top envelope telling us that it was extended when compared to its 12-month moving average. Prices could stop anywhere but they are probably going to hold around the 12-month average line around 2,541. Market observers may also want to remember that secondary reactions (within Dow Theory) run around three weeks to as long as three months. It would not surprise me that this correction ends sooner than three weeks.
Bottom line: Traders and investors need to remember that Technical Analysis is a wind sock at the airport and not a crystal ball -- it can help with the direction and timing of moves but do not expect a crystal ball forecast.
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