Dow Theory raises bearish red flag
Dow Theory, a market-trend forecasting system developed in the late 19th century by Wall Street Journal editor Charles Dow, is close to signaling that the primary trend of the market - which has been up for five years - is down, or bearish.
"The market is at a big inflection point," says Chuck Carlson, contributing editor of "Dow Theory Forecasts" newsletter. According to Dow Theory, if the Dow industrial average (made up of companies that make goods) and the Dow transportation average (made up of companies that ship goods) both breach significant market levels, it confirms a trend change.
The transports are trading below their August low, when the credit scare first hit stocks. What is worrisome is that the industrials, after plunging 4.5 percent the past three sessions, are hovering less than 197 points, or 1.5 percent, above their August low. If the industrials close below their Aug. 16 low of 12,845.78, it would confirm that the market trend has turned bearish.
"Dow Theory looks at significant points on the downside and upside," says Carlson. "If stocks breach those points, such as the dark period in August, it means something significant is going on. If both the industrials and transports are moving lower in tandem, it's not good for the economy, profits or stocks."
Stocks have been weighed down the past month by round two of a credit crisis that began this summer but has resurfaced in the past few weeks amid a slew of losses reported by major U.S. banks. These institutions are suffering from exposure to securities tied to risky mortgages that are declining rapidly in value.
Last week, the Dow industrials fell more than 550 points, or 4.1 percent, to close at 13,042.74 - 7.9 percent off their all-time high of 14,164.53. The pain of the current sell-off is approaching the 8.2 percent decline suffered in August from July's all-time high.
The catalyst for the downdraft was a drumbeat of bad news from the financial sector. On Friday, Wachovia, the fourth-largest U.S. bank, reported a drop of $1.1 billion in the value of its mortgage-backed debt. Bank of America and JPMorgan Chase also warned of more losses to come in the fourth quarter. Those reports follow write-offs announced earlier in the week by the nation's biggest bank, Citigroup ($8 billion to $11 billion) and Morgan Stanley ($3.7 billion).
Stocks have also been under pressure from the fallout caused by a sharp drop in the value of the U.S. dollar, soaring energy prices and fears of rising inflation.
But the still unquantifiable losses due to the credit crunch are what really has Wall Street on edge. "It shakes the confidence of the financial system," says Pat Adams, portfolio manager at Choice Funds.
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