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Dow Theory is flashing red Add to ...

A lot of people are talking about Dow Theory these days. The problem is that they can’t quite agree on whether the technical indicator is bullish.

According to the indicator, a market trend is supported when the Dow Jones industrial average and the Dow Jones transportation average both hit new highs. Or, to put it another way, the Dow’s gains signal that surging transportation stocks are moving for a good reason, since the former consists of companies that make stuff and the latter distributes those products.

The Dow has risen 9.9 per cent since mid-November and is now at its highest level since late 2007. The transportation average – which includes Union Pacific Corp. and FedEx Corp. – has risen 18.2 per cent over the same period and is now at a record high.

Add bullish-looking market breadth, price momentum and volume to the mix, and stocks look set to perform well, according to Mary Ann Bartels, head of U.S. technical analysis at Bank of America.

“This confirms the DJ Transports breakout and gives us a new Dow Theory buy signal,” she said in a note.

She believes that the S&P 500 is on track to crack the 1500-1550 barrier – marking a further gain of as much as 3.7 per cent. Perhaps more important is her view on downside risk: She argues that any concern about a bear market correction of 20 per cent or more this year has now been removed.

In fact, she believes that one of the few downside risks comes from surging sentiment readings, a contrarian indicator that raises the possibility of a “pullback” in February. Her advice: Buy on the pullbacks.

But not everyone is so taken by the Dow Theory. Bespoke Investment Group noted that the transportation average appears to be defying gravity after its two-month rally. As of Tuesday, the index was 9.3 per cent above its 50-day moving average.

“While very high, this spread has actually been higher four other times during the current bull market,” Bespoke said on its blog. “The last two times the Transports index got this extended, it stalled out once it got to 10 per cent above its 50-day, which isn’t very far off from where it is now.”

Mark Hulbert, a commentator at MarketWatch who keeps a close eye on what investment newsletter writers and theorists are saying, also pointed out that at least one Dow Theorist doesn’t believe the indicator is flashing a bullish signal right now.

Richard Russell, editor of Dow Theory Letters, believes that the Dow Jones industrial average must hit a new record high – not just a five-year high – before it confirms the move by the transportation average. On Wednesday, the Dow was about 2.7 per cent below its record high of 14,164.65, in October 2007.

“This intramural bickering between various Dow Theorists might prompt you to dismiss the Dow Theory altogether,” Mr. Hulbert said. “What real value can there be to a market-timing system that is open to such radically different interpretations?”

But that’s all part of the joy and frustration of various technical indicators: If everyone followed the same indicator, it would never work.

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