Assessing Market Direction
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 newspapers, stock market pundits and supposed “gurus” are always looking to give you their opinion. But who should you believe? You should form your own opinion.
This section will show you one of the ways to form a hypothesis about the market based on stable Technical Analysis.
Dow Theory has five tenets.
1. The market discounts everything.
2. The market has three trends, Primary (from months to years), Secondary (weeks to months), and Minor (days to weeks). Charles Dow holds that minor trends can be random, but the other two 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 investors begin 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 synch to have a solid trend. When both head down, this is the start of a bear market, for example.
5. Market Action. Volume is essential, and a market moving up on increasing volume is healthy. A market moving down on increasing volume is a warning sign.
Stock Market Crash Example 2009
The 2009 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.
Forming an opinion
Price – In the upper part of the chart, we can see that all three indexes have made a substantial recovery so far. The Transports (Blue Line) fell the hardest but have also recovered exceptionally well. All three are in a critical resistance zone.
Volume – Since the market bottom in March 2009, stocks have recovered, but the amount has been decreasing.
Money Flow – Chaikin Money Flow is an excellent indicator as it utilizes both price and volume. It has a unique ability to contradict prices and give early warning signals. Watch this closely. It took a significant hit in the last four weeks but is showing signs of a recovery. If this continues down when the price is increasing on a 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 uptrend.