Editor's Note: The following article was written by Raymond James Chief Investment Strategist, Jeff Saut. It has been reproduced with permission for the benefit of the Minyanville community.

Last Monday, my email inbox was slammed with questions about Dow Theory. Those questions were kindled by some alleged pundit who appeared on CNBC and declared that a Dow Theory “sell signal” had been rendered. While it's true that there are numerous practitioners of Dow Theory, over the years I've learned that many of them don't interpret the theory the way I was taught.

Charles Dow began publishing the Wall Street Journal in 1889. Considered a very astute stock market observer, Dow wrote a number of editorials wherein the concept of Dow Theory originated. Those theories were expanded on by S.A. Nelson, in collaboration with Charles Dow, in a series of Wall Street Journal editorials titled, “The ABCs of Stock Speculation.”

At the end of those quips resided a footnote that read “Dow Theory.” Shortly after Dow’s death, William P. Hamilton became editor of the Wall Street Journal and wrote hundreds of similar editorials, leading to his epic book The Stock Market Barometer. It was Hamilton who first wrote about the “confirmation principal” between The D-J Industrials (DJIA) and The D-J Transports (DJTA), which to me, is the bedrock of Dow Theory.

Following Hamilton’s death in 1930, his student, Robert Rhea, began publishing a market letter titled “Dow Theory Comment.” Rhea “called” the bottom of the stock market in July of 1932, as well as the subsequent downturn of 1937. Rhea died in 1939, leaving Dow Theory fallow until the 1940s when the great Dow Theorist George Schaefer resurrected it. To me, these folks were the “expanders” of Charles Dow’s original stock market observations. And to my knowledge, the only market maven of today that really understands and adheres to the brilliant work of those Dow Theorist icons is Richard Russell of Dow Theory Letters fame.

While I could certainly respond as to why there was NO “sell signal” last Monday, Dick Russell explained the situation in his always-excellent letter dated October 26, 2009 (the text in parentheses are my inserts). To wit:
 

The secret of the direction of the great primary trend of the market lies in the secondary reaction and what happens AFTER a secondary reaction. A secondary reaction usually takes three weeks to three months in duration while correcting one-third to two-thirds of the previous move. Since the March low, we have yet to experience a true secondary reaction. And I'm wondering whether we could be on the edge of a secondary reaction now. Following a secondary (reaction), if BOTH Averages (Industrials and Transports) rise to new highs, the primary trend is taken to be bullish. Following the lows of a secondary reaction, there will be a rally. If (that) rally fails to take both Averages to new highs, and the Averages then turn down and break to new (reaction) lows, the primary trend is taken to be as bearish. Secondary reactions often start with one of the Averages sinking while the other Average continues to the upside.

Well said, Dick Russell. I, therefore, told my callers: “How can you have a sell-signal when we haven't even experienced a downside secondary reaction since the March lows?” Indeed, you need a downside reaction, which “sets” the reaction lows, followed by a rally. If that rally fails to make a new reaction high, and subsequently breaks below the aforementioned reaction lows, then (and only then) will we have a Dow Theory “sell signal,” at least as I understand Dow Theory.