When is a Theory More Than Just Theory? (DIA)
No trading system is perfect. There are those that are fashionable, suited to a particular market, era or investment milieu. Then there are those that seek to exploit particular knowledge or technological advantages, or other quirky market realities – like arbitrage, long/short schemes, trend following systems, quant strategies or technical analysis, to name just a few.
And beyond these, there are simply systems that have been around for a good long time, and have weathered the test of history.
One of these is ‘Dow Theory’, and we’ve highlighted the strategy here a number of times over the years, initiating a number of very successful trades from it, as well.
In short, it’s an examination of the relationship between the Dow Jones Industrial Average (DJIA) and the Dow Jones Transportation Average (DJTA), with an eye towards determining whether we’re in a bull or bear market in stocks.
And while some may say that today’s market is filled with tech issues that have nothing to do with the old world of railroads and airplanes, we can only counter that the proof is in the pudding, friends: this may be a new world of nanobytes and genosplicing, but Dow Theory has been consistently effective in offering long-term market timing calls on the broad market for better than a century.
Very generally, the theory is based on the notion that increased orders for DELIVERY of goods (transports) will precede the actual PRODUCTION of goods (industrials) when stocks are in a bull market. That’s because transport orders have to be booked well in advance of production in order to ensure they get to store shelves when demand is hot.
It also means that the transportation stocks should be moving higher – and the industrials should be following – during a typical bull cycle.
Conversely, orders to transport product will likely contract prior to those same factories curtailing production, meaning a decline in the transport stocks generally leads a decline in the industrials when demand diminishes and markets become bearish.
And the trading system itself? How does it work?
Again, in broad strokes, it looks like this –
The two averages have to confirm one another’s new highs and lows in order to signal a Dow Theory “confirmation”. When they confirm new highs, we’re in a bull market. When they confirm new lows, we’re in a bear market.
The tricky part comes when one index hits a new high (or low), and the other hasn’t yet had a chance to confirm. This is a very common phenomenon, and is called a Dow Theory non-confirmation. It can also persist for months, if not years, before being resolved. All the while, Dow Theorists are in a state of uncertainty, and during the non-confirmation period the market can take some wild swings.
It goes without saying that this can lead to potentially dangerous losses for those who choose to wait out a confirmation.
So where are we now?
Thankfully, since last week, no such indecision exists for those who follow the system.
As the chart below shows, the Dow Transports registered a new all-time high four trading sessions ago, touching the 9700 level before drifting ever so slightly below. And with that we have new proof that the markets are in full bull mode.
Stay tuned for a new push higher.
And take a look –
As you can see, the Dow Theory bear signal that existed through November, 2016 became a non-confirmed bull situation once the Industrials punched into record high territory with the election of a new President that same month.
But the transports weren’t yet convinced. And though they’ve been on the rise from the beginning of 2016, it wouldn’t be until just last week that they punched to record new highs and pulled away from a seven month dance they’ve been doing with former highs set back in the spring of 2016.
The latest moves from the Trannies have the decidedly bullish complexion that was lacking in former moves through the 9500 area.
With last week’s action we have new, positive proof of the health and direction of the current bull market.
New Trades and Old
Before we get to this week’s initiative, just a brief look at our trade from a week ago. It was a long PUT on Tesla with a 280 strike that we paid for with three (3) short PUTs at 240. All expiries were set for September.
And look what’s happened since –
The chart shows a glorious dive since we laid on the trade, and also where our long and short PUTs are situated (in green). The upper green square is the long option, the line to which we fully expect to descend. The lower square, where significant support emerges with the long term moving averages, is where we sold our PUTs. We’re quite confident that any descent to that region would trigger a potent buying reaction, leaving the short PUTs safely out=of-the-money.
We’ll of course be keeping a sharp eye for developments here. We have great hope that the trade will be a whopper!
Now for the News!
We’re going to play the long side of the market this week, for two reasons. The first is the aforementioned Dow Theory bull signal that we got last week, a stake in the heart of the current decline in stock prices. And the second is the current level of bullish sentiment from Main Street, which, according to the latest numbers published by the American Association of Individual Investors (AAII), has receded to depressed levels, sub-thirty percent.
Have a look –
With everyone out of the pool, we see a perfect time to throw on our flippers and take a contrarian dip.
And so we’re doing.
We’re initiating a straightforward synthetic long position on the SPDR Dow Jones Industrial Average ETF (NYSE:DIA), which has been stuck in a range for five months now between 204 and 214.
And it goes like this –- Content protected for Normandy Executive Lounge, Wall Street Elite, Executive Lounge members only]
With kind regards,
Hugh L. O’Haynew