It would take only a small market drop on Friday to trigger something big — a sell signal from the famous Dow Theory.
This is important, for two reasons. The first is that the Dow Theory has been beating the market for an awfully long time. One academic study from the 1990s calculated the Theory’s track record over the prior seven decades, back to when it was created in the early part of the last century; the study found that the Dow theory beat the market by of 4.4 percentage points annualized.
Read: Dow closes more than 700 points lower as trade fears spark plunge
The second reason to be on your guard for the possibility of a Dow Theory sell signal: The timing system is widely followed, so a sell signal could generate an avalanche of selling. Among the investment newsletters I monitor, for example, no market timing system is more widely followed. Countless individual traders use it to decide when to build up cash.
To get an idea of what such a selling avalanche could look like, consider the mini-crash that occurred on Feb. 5 of this year. The Dow DJIA, -2.93% dropped nearly a 1,000 points in less than 30 minutes during that day’s trading, and though the market later in that session recovered some of that plunge it still ended the day down 1,175 points — its worst point drop in history. Though a Dow Theory sell signal wasn’t to blame for the deluge of sell signals that day, many analysts pointed to other timing systems whose trigger levels were breached that day.
To appreciate just how close a Dow Theory sell signal is, read my March 2 column in which I detailed the three-step process required to generate such a signal. Suffice it to say that the market has already jumped over the first two of those steps. The third and final step requires the Dow Industrials to close below 23,860.46 and the Dow Transports DJT, -2.85% to close below 10,136.61.
That would require a drop of just 0.40% on the part of the Dow Industrials and 2.1% for the Transports.
Read: Here are the biggest Dow and S&P 500 stock losers in March
Though the Dow Theory traditionally focuses on closing levels for these two Dow averages, you can bet that some investors will jump the gun before the close on Friday if it appears as though those averages are about to drop below the requisite levels. If so, the end of Friday’s trading session could be especially ugly.
In the meantime, the Dow Theory officially remains bullish. That’s because one of the cardinal principles of the theory is that the most recent signal remains in force until it is reversed. And the most recent Dow Theory signal was bullish. But this situation could soon change.
For more information, including descriptions of the Hulbert Sentiment Indices, go to The Hulbert Financial Digest or email [email protected] .