I’ve studied and utilized a plethora of market theories and indicators over the years, many of which I still use on a regular basis.

Of all the methods out there, the Dow Theory is arguably the oldest market timing system. Created more than 100 years ago from editorials written by Charles Dow, the founder of The Wall Street Journal, it’s also a theory I can easily examine, deconstruct and “build” with relative ease because of my years of experience working with it.

#-ad_banner-#Today, I’m going to explain what the Dow Theory is telling us today — and how I plan to profit from it.  

Dow Theory is based on the premise that the economy grows when manufacturers are producing as much as possible. Economic growth translates into profits for companies in the industrials sector, which should show up in the performance of their stocks. Getting goods to market requires that the transportation industry also be growing, which should drive the stocks of transport companies higher.

This makes sense considering increased consumer activity and health should mean more cars being driven (automobiles and fuel), more goods being shipped (rail and parcel services) and more travel (airlines).

In other words, in a healthy market environment, the Dow Jones Industrial Average is making new highs, and the Dow Jones Transportation Average should be moving upward alongside it. Movements in the two averages must confirm each other to show a trend change. If the two are NOT moving together, Dow theorists then look for three tests to trigger a proper sell signal:

1) Both averages experience a significant correction from new highs.

2) Following the correction, at least one of the averages fails to rise above its pre-correction high.

3) Both averages drop below their most recent lows, generating a sell signal.

Take a look at this chart to see what I mean…
 

The first signal came when the Dow industrials tumbled 4.1% from late December to mid-January while the Dow transports fell 5.9%. The second was met when neither index was able to surpass its previous high during the short recovery rally from those mid-January lows. Finally, the third occurred on Jan. 28 when the industrials closed below their previous lows and the transports followed suit two days later.

Since then, the industrials have been struggling in a sideways pattern while the transports have continued to disintegrate, losing 7.8% since their January high.

Looking back at data from the past 50 years, in the six months following a Dow Theory sell signal, the S&P 500 falls an average of 14.3%. Based on what the chart above is telling us today, we could see history repeat itself.

Yet even though the market has been flashing a sell signal since early February, most stocks have traded sideways. But others, like some in the transport sector, have seen their worst performance since the Great Recession.

Now, I agree with Dow theorists and others that this indicator is signaling a correction. I’ve expressed before how frothy I believe the stock market is. But instead of betting against the broader market, which can have a laundry list of other influences, it’s better to find the most vulnerable stocks and target those instead.

We’ve already established the Dow Jones Transportation Index as a weak point. And after deconstructing the sell signals recently, I discovered a company that’s dragging the transports lower. My research suggests it’s poised to continue falling, providing readers of my premium newsletter, Profit Amplifier, a perfect short opportunity.  

Now if you’ve never shorted a stock, that’s okay. It’s not nearly as daunting (or risky) as most investors believe it to be. It’s just as easy as going long a stock.

But knowing, or at least understanding how to short stocks, is a vital strategy if you want to beat the market or hedge your portfolio — especially when the market is showing warning signs of a correction like it is today.

I don’t have room in today’s issue to get into the full details on shorting, but let me give you a quick example of how it’s worked for us in the past.

At the end of last month I sent an alert to my readers providing them with a detailed analysis on why it was a great time to short Alibaba (NYSE: BABA). I said that with the slow economic growth out of China, downward earnings revisions for the company by analysts and the recent drop in sales, Alibaba could see its share price fall.

Then I gave my readers step-by-step instructions on how to profit from Alibaba’s downfall.

We closed out the trade only a couple weeks later as shares took an 8% hit — but thanks to the way we short stocks (by using options), we made a gain of about 69% on the trade.

And the thing is, the transportation stock I’ve identified is set up to do nearly the exact same as Alibaba. If everything goes as planned, my readers and I will book another big winner (more than 35%) — even if this company pulls back only 8.3%.

I can’t give this stock away here, since I just released it to my paid subscribers, but there’s still time to get in on this trade (by the way, I don’t only short stocks in Profit Amplifier — I also show readers how to get double-digit returns from only a small upside move in stocks as well).

If you’re interested in getting this recent trade as well as all future trades sent to your inbox, then go here. And if you’re interested in learning more about making money when the market takes a hit, I’ve put together a research report, Using Options to Survive — and Profit From — a Market Crisis, that explains everything you need to know. You can learn how to get your hands on that report here.