- Dow Theory suggests the rally has the strength to continue.
- Beware new developments with coronavirus, and other risks, to potentially shift the market's upward momentum.
Since the March bottom, US stocks—as measured by the S&P 500—are up 46%. Yet they have broadly tread water since early June, as a surge in new COVID-19 cases has caused the rollback of some reopening plans. The result, in the context of current market conditions, appears to be an unclear path forward for stocks.
If you are an active investor looking to identify the primary direction that the market may go over the near term and you like using charts to supplement your fundamental analysis of investment ideas, consider utilizing Dow Theory—the foundation of technical analysis created by Charles Dow, cofounder of the Wall Street Journal and the Dow Jones Industrial Average. Key elements of Dow Theory now suggest stocks may be able to move higher over the near term.
What is Dow Theory
Much of technical analysis—the method that attempts to find patterns and trends based on market behavior and investor psychology—derives from Dow's findings that markets move in trends. Dow, who died in 1902, used the analogy of the ebb and flow of tides to describe how the market acts. He believed that stocks move in trends, similar to how waves crash onto the beach, and leave patterns in the sand to show where high and low tides occurred. If you can use these patterns to identify the direction of market trends, you may be able to better position your portfolio.
When Dow was researching the market in the late 1800s, there were far fewer stocks, and indexes were not as commonly used as they are now. Dow created 2 indexes, or averages, as they are referred to in Dow Theory: Industrials and Transportation (also known as Transports). These averages served as the basis for his analysis of primary and secondary trends.
Here are the key tenets of Dow Theory:
- The averages discount everything (i.e., they reflect all relevant market information).
- The market moves in waves and trends, and a trend is assumed to exist until evidence suggests it has reversed.
- Volume must confirm the trend.
Dow believed that markets are forward-looking and that past price movements can help discern probable future price trends. This is the crux of all technical analysis. Chart analysts believe that Dow Theory presents an opportunity to step back from the day-to-day fluctuations of the market and help understand longer-term primary trends.
Dow Theory in action
If there is one critical application of Dow Theory to know about, it is that the averages must confirm one another. Dow was referring to the Dow Jones Industrial Index and the Dow Jones Transportation Index.
For example, suppose that during a bull market rally the Transports made a new relative high (a price that is higher than the most recent data, which can be several weeks or months) but the Industrials did not. That the averages did not confirm one another (both did not make new relative highs at roughly the same time) may indicate that a reversal of the trend could be on the horizon. Consequently, Dow Theory suggests that both averages could fall below a significant support level.
Not only did Dow believe that the movements of the 2 averages (Industrials and Transportation) must confirm each other, he also thought that volume for 1 or both averages must confirm the trend. Volume confirmation is an indicator that can apply to any investment. For example, if a stock rises and volume rises (relative to a recent time frame, say, the past several weeks or months), that means volume has confirmed the uptrend. Similarly, if a stock declines and volume rises, that means volume has confirmed the downtrend. Dow assumed an existing trend to be in place until clear signals, confirmed by volume, indicated that it has reversed.
The principles of Dow Theory laid the foundation for much of the short- and long-term technical tools and chart patterns that have followed Dow's work.
Dow Theory now says...
A current chart of the S&P 500 shows both the industrials and transports have been trending higher since the March COVID-19-induced bottom. Indeed, the averages confirm the uptrend—according to the core tenet of Dow Theory (see Dow Theory shows both averages are rising chart). While the picture is not entirely bullish (in June, both averages made lower lows), both averages have made higher highs and higher lows in recent weeks.
If you look back to late 2019 and early 2020, the averages did not confirm one another. Industrials were steadily rising while transports were mostly trending sideways. Of course, stocks plunged in late February and March, not because of this divergence, but because of the unfolding COVID-19 situation. The divergence between the averages is not necessarily a sell signal, but rather a lack of confirmation of the uptrend.
The volume picture is not as clear as the price action. Volume is down from its peak during the height of the selling price in March, but that is largely to be expected, given the lingering concerns surrounding COVID-19 as well as a seasonal effect where volume tends to diminish over the summer months. It is slightly higher than the same time last year, which would be evidence of volume confirming the trend, but that might also be a result of increased activity from the pandemic. Consequently, it is difficult to determine if volume is confirming the trend in the averages.
A last point about Dow Theory
Critics of Dow Theory (and of technical analysis in general) might say that price behavior alone is not sufficient information on which to base an investing decision. Additionally, Dow Theory relies on 2 indexes that have changed composition dramatically since the theory was created more than 100 years ago. More importantly, signals given by Dow Theory and other indicators may be rendered irrelevant when powerful market events—like the ubiquitous impact of COVID-19—overwhelm any value of assessing underlying market psychology through price action.
That's why you might consider using Dow Theory in combination with other tools and methods, including fundamental analysis, to help identify trends and potential changes in trends. With that said, Dow Theory, created by the father of technical analysis, may provide useful insight into this market.