Assessing Market Direction is critical before buying a Stock !

Using a mix of Dow Theory and the right indicators it is possible to understand the current character of the market.  On TV and in newpapers stock market pundits and supposed “gurus” are always looking to give you their opinion.  But who should you believe.? I think you should form your own opinion.  This article will show you one of the ways to form a hypothesis about the market based on solid Technical Analysis.

Dow Theory has basically 5 tenets.

1.  The market discounts everything.

2. The market has 3 trends (Primary, from months to years) Secondary (weeks to months) Minor (days to weeks)  Charles Dow holds that minor trends can be random but the other 2 are parts of a cyclical trend.

3. The Primary trend has 3 phases, Accumulation, (the far sighted investors who have see a potential recovery) Public Participation (company earnings are proving good and the general public starts to participate), Distribution (far sighted investor start to sell as they see Stock Price growth is unsustainable in comparison to company earnings or economic climate).

4.  The averages must confirm.  Using the Dow Jones Industrial Average and the Dow Jones Transports, both must be in sych to have a solid trend.  When both head down this is the start of a bear market for example.

5. Market Action.  Volume is important and a market moving up on increasing volume is healthy.  A market moving down on increasing volume is a warning sign.

The Chart below shows the Dow Jones 30, the Dow Jones Transports and the S&P500, side by side in a line chart.  Also I have included Chaikin Money Flow, Volume and the DMI ADX indicator.  Important indicators for us to form our opinion.

Using Charts to forcast market direction.

Forming an opinion.

Price.  In the upper part of the chart, we can see that all three indexes have made a strong recovery so far.  The Transports (Blue Line)  fell the hardest but have also recovered extremely well.  All three are in a key resistance zone.

Volume.  Since the market bottom in March stocks have recovered but volume has been decreasing.

Money Flow.  Chaikin Money Flow is as great indicator as it utilises both price and volume.  It has an excellent ability to contradict price and give early warning signals.  Watch this closely.  It took a significant hit in the last 4 weeks, but is showing signs of a recovery.  If this continues down when price is increasing on lower volume this is a warning sign.

ADX Average Directional Index.  ADX between 20 and Zero suggests that a trend (either up or down) is stalling and there may be a sideways consolidation or a change in direction.  Here we see ADX registering at 28 which signifies a weaker trend however it is still an up trend.

Summary Opinion.

The market is at an important place.  The market has already undergone the accumulation phase of the new Bull Market, next the public participation phase may come if company earnings continue to show further improvement.  Today we are at key resistance levels and the market certainly could sideways consolidate for a while.  There are no strong indications of a major move either up or down.  Volume is shrinking but it could be a sign that the market is catching its breath before the company earnings announcements coming later this year.  This is probably a good time to be looking for stocks that are industry leaders, with fantastic earnings, solid fundamentals and a bright future.  See the article on Stock screening to help you find those stocks.

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