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Jeff Saut: A Greater Observation Than Dow's Buy and Sell Signals?


An explanation of one interpretation.


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

Minyan Gary writes:

I very much enjoy reading your weekly market comments reproduced in Minyanville, and have enormous respect for your insights. Your feel for the market has been nothing short of uncanny, which is why I'm writing for your comments.

I'm of the understanding that one of the greatest observations that Charles Dow gave us was that a "move in the primary trend" would consist of three distinct segments separated by two counter-trend segments canceling three-eights to five-eights (later refined by modern day technicians to the Fibonacci relationships of 38.2 and 61.8) of the previous segment. (I believe this formed the basis on much of Ralph N. Elliot's work.)

I always thought this observation was more significant than the Dow "Buy" and "Sell" signals.

This was indeed the case in the March 2000 through October 2002 decline, as there were two (and only two) counter-trend rallies of greater than three-eights, one 49% and one 60%. (4/3/2001-5/21/2001) and (9/21/2001-1/04/2002). I noticed the same principle can be applied to the September 1929-July 1932 bear market.

If the same were to apply to this bear market, then we'd have to be on the precipice of another leg down, as this is only the second rally greater than three-eights.

The first leg down of the bear market began at the S&P 500 all-time high of 1565.15 on October 9, 2007 and lasted through March 10, 2008 when the index closed at 1273.37 (a decline of nearly 20%). The subsequent counter-trend rally recovered approximately 50% of the decline and carried the index back to 1426.63 on May 19, 2008.

The second leg down then began and carried the index down to a close of S&P 676 on March 9, 2009 (a decline of 750 points: 1426 minus 676). A subsequent counter-trend rally is still unfolding. A 61.8% retracement of the 750 point decline would be 463.5 points from the 676 close or 1139.5. With the S&P at approximately 1110 there wouldn't be much more upside if this principle would hold true, and a third leg down would unfold. No prior rally (such as November 20, 2008 through January 6, 2009) retraced the minimum three-eights of the prior decline.

This current bear market has been tracking the 2000 through 2002 decline very closely as the counter-trend rallies have been almost identical.

I'd appreciate your thoughts on the validity of my understanding of Charles Dow's observation. Is this principle indeed part of his work or a misinterpretation? Or does the fact that the bear market decline of 2000 through 2002 followed this principle somehow negate the usage this time? I've often read about this principle in regard to bull markets, but always believed that it referred to "moves in the primary-trend" and therefore could be applied to bear markets as well. It certainly did me well 2000-2002.

I believe your target is higher than S&P 1139.5 so you must feel this won't play out again this time; that's the cause for my concern with this analysis.

While Charles Dow did indeed speak of five waves, as I was taught, this has nothing to do with Dow Theory. Speaking to your other points:

My target of 1200 is only about 5% from yours of 1140 -- no big deal, especially after the worst price decline and economic crisis since the '30s

2. Due to the cycle of "fear, hope, and greed" on the part of individual investors, markets go to extremes in both directions. Hence I go back to point number one.

3. Performance anxiety, bonus anxiety, and ultimately job security on the part of institutional investors are also reasons why I wouldn't fret about a 5% difference.

From my perspective, non-confirmations are developing, which should put us all on a more heightened stance of readiness.

Finally, if you're expecting new lows (I'm not) below the March 2009 levels, my response is that given the fact that Dow Theory gave a "sell signal" in September 1999, a "buy signal" in June 2003, another "sell signal" in November 2007, and while it didn't render another "buy signal" until July 2009 I did indeed target the March lows, I feel pretty confident that if that level (March 2009 low) was going to be violated, we would be able to identify it prior to it occurring.

See also, Jeff Saut: Why a Dow Theory Sell Signal Never Happened.
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