Dow 13,000: Be Very Careful Here

Pop the champagne corks!

If you haven’t noticed, or you've been completely shuttered from the mainstream media outlets, the widely followed Dow Jones Industrial Average (DJIA) finally closed above 13,000.  After three previous failed attempts over the past week or so, it finally stuck when they rang the closing bell on Tuesday.

Yippee!

Yeah I get it.  It’s a big deal for John Q. Public and Family, who've seen their 401k and stock investments go through the ringer ever since the market implosion kicked into high gear in 2008.

Hey, speaking of that fine vintage year, the last time the Dow closed above 13,000 was back in May of 2008, nearly four years ago.

Now I guess you can't blame the media for making such a big deal over this.  After all, it's their job to sell the sizzle, not necessarily the steak. 

And a nice round number like 13,000 does indeed strike an alluring tone with the masses as a sort of grand milestone.  I'm sure many average investors who've been reluctant or gun shy about jumping back into the financial markets are probably starting to feel the juices flow again.

I certainly can't blame anyone for wanting to stake their claim in the markets, and I especially commend investors who have had poor results in the past and are willing to try again.  After all, that's why IFII was founded -- to help self-directed individual investors achieve their investing goals.

There are two important points I want to make today.  Then, I'm going to share with you a very powerful tool involving the Dow that you can use to make better investing decisions... one that right now is sending up a huge red flag.

The first point: Don't ever let the mainstream media influence your investment decisions when it comes to price action.  It's very important that you do your own technical analysis and due diligence when it comes to framing your sentiment.

For example, while all the hype surrounding the Dow has centered on the "milestone" of Dow 13,000, the real story of relevance actually occurred nearly a month ago:



That’s right.  In early February, the Dow made a closing high above the cyclical high of last spring (blue arrow) -- a level of very meaningful importance... at least to traders and investors who are serious about making money.

But to the mainstream media, the Dow closing at 12,862.23 doesn't exactly have the "sizzle" to make such a big fuss about.  But Dow 13,000 (red arrow) seems like a story that can grab a lot of attention from the viewership, even though in reality it's simply a round number with shallow substance.

So tune out the media when it comes to price action... at least don’t buy into the hype.

The second point:  Don't get into the habit of formulating your market sentiment based on what the Dow is doing.

True Story:

It was my first day on the trading floor as a trader/trainee, and I was clerking for a senior trader who later became my mentor.

At the end of the day he asked me, "So Costas, how did the market do today?"

I proudly responded, "The market was up 201 points today."

"Wrong!" he replied.

Huh?  "The Dow finished up 201 points -- it closed at 8,107 -- I'm sure of it."

Then he asked me, "Costas, you want to make a lot of money, don't you?  You want to become a great options trader... That's why you're here, right?"

"Yes," I replied with enthusiasm.

He then tells me: "The market was up 21 points... The S&P 500 index closed at 1,001.  Costas, if you want to be successful in the market, you need to focus on the S&P, not the Dow.  The Dow is for the masses and the USA Today, the S&P is for the money makers."

Of course, I had to ask why.  And this is what I learned on my very first day about the Dow.

The Dow has three weaknesses when it comes to using it as your primary frame of market sentiment:

1. The index consists of only 30 stocks.  Basically, the sample size is too small when it comes to using it as a frame of reference for gauging the broad market.
    
2. The index is price weighted, meaning that it disregards the market capitalization as a contribution to price movement.  Currently, the divisor is roughly 7 Dow points for every 1 point move of any one component of the index.  This means that the index is very susceptible to showing you price action that could easily be skewed by one or two individual stocks and could otherwise mislead lead you into making incorrect assumptions about the overall market landscape.
    
3. Out of all the widely followed indices, the Dow is the one that is most susceptible to market manipulation.  The primary dealers and big investment houses can "massage" the index.  The index is particularly vulnerable towards the close of trading as large market on close orders can influence the closing prints in nearly all 30 of the components, which in turn affects the index price.

So, when it comes to trying to formulate your market sentiment, don't use the Dow as your primary focal point.  I have been following the S&P 500 for years, and it still serves as the best measure for the broad market.

Okay, now that I’ve made my two points, I’m going to share with you a powerful piece of information that IS useful when it comes to following the Dow.

Where I do see relevance and value in the price action of the Dow is when I study the price action in conjunction with its sister index, The Dow Jones Transportation Index (DJT).

The DJT is made up of 20 components -- it contains airlines, shippers, truckers and railroads.  Basically, it's comprised of companies that transport global commerce.  For reasons you can probably figure out, they are usually seen as a leading indicator of the health of economic growth.

In trending bull markets, like the Dow is currently exhibiting, you'll want to see the Transports either lead or at least keep pace when it comes to relative strength performance.

One confirming the other is a time-tested technical indicator and a cornerstone of classic Dow Theory when it comes to the conviction of trend.

So I essentially use the Dow as a second set of eyes when I look for clues on forecasting the markets.  Overlaying the Transports can show you some very valuable information.

 
You can clearly see how tight the relative strength correlation has been since the market bottomed in October.  The Transports either led or kept pace on a relative strength basis until early February.

Today you're seeing a big divergence as the Dow has pushed a bit higher while the Transports have been exhibiting significant weakness.

This is a huge red flag!

Without the Transports picking up relative strength, it's going to be very difficult for the Dow to carry above 13,000 with any real substance.

What will eventually happen is that the indices will again converge.  But based on the broad market's overbought condition in the short term, high oil prices digging deeper into consumer wallets, and European growth slowing down, the probability points to the Dow coming down to the Transports, at least in the short term.

I only wonder what the mainstream media would say about that.

Costas Bocelli
Contributing Editor
Channel Trading Secrets