Dow Theory: Forecasting A 2011 Style Market Correction

Dow Theory: Forecasting A 2011 Style Market Correction
Potential of a 15% Hair Cut

by Chris Vermeulen

Over the past few weeks I have been watching the DJIA (DIA) and Transportation index (IYT) closely because it looks and feels like the Dow Theory may play out this year and the stock market could take a 15% haircut.

Keeping this post short and sweet, I think the US stock market is setting up for a sharp selloff.  And it will look a lot like the July 2011 correction.  If my calculations are correct this will happen in the next 3-9 weeks and we will see a 15% drop from our current levels.  Only time will tell, but I have a way to hedge against this with very little downside risk to you ETF portfolio.
 
The Dow Theory Example

The daily chart of the S&P 500 (SPX) (SPY) index below shows our current trend analysis with green bars signaling an uptrend, orange being neutral, and red signaling bearish price action.  Currently the bars are green and we can expect prices to have an upward bias.

The Dow Theory could be in play.  When both the Transports and the Dow Jones Industrial Average cannot make higher highs and start making lower lows, according to the Dow Theory the broad stock market is topping.

We are watching the market closely because they have both made lower highs and lows.  This rally could stall in the next couple weeks and if so we expect a 15% correction.

E Mini, DIA, IYT Chart

Take a look at the 2011 Stock Market Crash:

2011 SPY Chart

The chart above shows how fearful traders have a delayed reaction to moving money from stocks to a mix of risk-off assets.

The choppy market condition during August and September clearly helped in frustrating investors and created more uncertainty. This is something I feel will take place again in the near future.

Because we have a Dow Theory setup, our risk levels are clearly defined as to when to exit the trade if it does not play out in our favor.
 

Courtesy of TheGoldAndOilGuy