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A Dow Theory 'sell' sign has the market nervous

Why the Dow theory is important

Traders on Tuesday were ready to shake off the detritus of Monday's market plunge with a follow-up rally, but some worried the good times won't last.

Those who follow Dow Theory, which uses the transportation and industrial indexes to gauge the strength and weakness of market moves, sent an ominous "sell" signal during the previous day's carnage. Both measures closed below their previous lows back in October, setting up a possibly dangerous scenario ahead.

Jeff Saut, the generally bullish chief investment strategist at Raymond James, said in his morning note to clients Tuesday that he believes Monday's movement put in a near-term market bottom, but one that may not last.

"While we were looking for a bottom today/yesterday, the quality of any ensuing rally will be VERY important to reverse yesterday's Dow Theory sell signal," Saut wrote. "Hopefully it will be a false sell signal like the one of May 2010. But, until it is reversed, I am going to be much more cautious than I have been over the past 6.5 years, even though I think we are going to get a near-term rally off of yesterday's lows."

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To be sure, Dow Theory is not without its critics, many of whom argue that the U.S. economy has changed over the years and is less dependent on transportation and industry and more on technology. Studies, though, have found Dow Theory to be a fairly reliable predictor that performs better in bear markets than bull markets.

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Saut referred to two particularly ominous and accurate Dow Theory warnings—in 2007 and 1999. Making this signal troubling is that the averages will need to travel a long way before reversing the sell signal.

"The upside prices for a reversal for yesterday's Dow Theory sell signal are much higher than participants want to anticipate currently. Indeed, they are thousands of points above where we are now," he said. "I have a great deal of respect for such sell signals. Therefore, while I think a short-term trading bottom is at hand, I am now cautious like I was at the Dow Theory "sell signal" of Nov. 21, 2007, as well as like I was from the Dow Theory 'sell signal' of September 1999."

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Tuesday's market opened with a strong rally, with major indexes registering gains in excess of 2 percent. Even with that in mind, though, the Dow industrials were off more than 9 percent year to date while the transports remained off more than 15 percent.

"Given the aforementioned oversold condition, we would look for a near-term trading bottom and subsequent rally," Saut said. "For the record, however, any ensuing rally is suspect with the stock market's internal metrics subject to extreme scrutiny."