Dow Theory Bear Market - Friday, Dec. 21

Both the Dow Jones Industrial Average (DJIA) and the Dow Jones Transportation Average (DJTA) have broken their last secondary lows. This officially puts Dow Theory in a bear market by my count.

Dow Theory Bear Market

So, what does this mean for trading and investing? First, what it doesn’t mean. It doesn’t mean you move all your money from long to short. Or from long to cash. The reason for this is that Dow Theory changes of long-term trend often happen just as the market is ready to make its first counter move of the new trend. In this case, it means we’re likely due for a counter-trend rally.

Now, on to how I use Dow Theory as a part of my investing strategy. I use it to as a part of the timing when rebalancing any hedges. Since we’re now in a bear market, I’m more likely to let the profits from the hedge run a little more than my “about 15%” rule. If we were in a confirmed Dow Theory bull market I’d be more likely to take profits sooner and use the money to buy more longs (expecting a resolution of the correction to the upside).

The other thing Dow Theory does for me is reverse how I look at technical analysis indicators. Now that we’re in a bear market the odds suggest that oversold conditions will get more oversold. Overbought conditions shouldn’t occur as often as they do in a bull and will likely be good times to add to short positions or firm up hedges (by selling longs and buying more VXZ). Basically, I try to change my mindset to believe that the most likely direction for the long term is going to be down, so when analyzing indicators pick the bearish interpretation.

In addition to Dow Theory signaling this week, lots of the long-term indicators that I follow have gone negative over the past month or so. Things like monthly MACD, NYUD falling below it’s 250-day moving average, and a point and figure chart of SPX breaking down from what appeared to be a consolidation range. TradeFollowers breadth indicator is signaling a bear market too with more bearish stocks on Twitter than bullish ones. So, there’s lots of evidence that the long-term direction (from 1 to 3 years) is going to be down.

Disclosure: Use your own judgement and personal risk preferences to allocate your own portfolios. And, of course, never trade a financial instrument that you don’t understand.

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