- Dow theory is a chart pattern that can confirm uptrends or downtrends for stocks.
- This indicator is flashing a worrisome sign.
- Investors should monitor key fundamentals like earnings, inflation trends, and other factors in addition to chart trends.
The Dow Jones Industrial Average—which represents 30 of the biggest and most influential US companies—has gained roughly 5% year to date on a price return basis, as of mid-July. That's a bit behind last year's pace, when the blue chip index had gained roughly 7% by this time. It's also well behind the nearly 18% surge for the S&P 500.
With markets broadly at all-time highs, many investors have questioned whether stocks can continue to rally on relatively weak market breadth or if stretched valuations and other headwinds may put the rally at risk. Dow Theory might be suggesting the latter.
What is Dow Theory?
Dow Theory is the foundation of technical analysis—finding patterns and trends, mostly in charts, based on market behavior and investor psychology. It was created by Charles Dow, cofounder of The Wall Street Journal and the Dow Jones Industrial Average.
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.
Dow Theory is based on 2 indexes: Industrials and Transports. 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 Theory indicator
If there is one critical application of Dow Theory to know about, it is that the averages (the Dow Jones Industrial Index and the Dow Jones Transportation Index) must confirm one another.
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) as did the Industrials. This would be considered a confirmation of the uptrend.
Alternatively, suppose that the Transports made a new relative high 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.
Not only did Dow believe that the movements of the 2 averages must confirm each other, he also thought that volume for one or both averages must confirm the trend. 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.
Dow Theory now says...
Stocks have broadly trended higher this year, including the Industrials. Notably, the Transports have not. In fact, the Transports are actually down year to date. This divergence between these 2 indexes may suggest the bullish broad uptrend for stocks could be at risk, based on this indicator.
In terms of volume, it has generally been marginally lower than prior months as well as compared with the same time last year. Of course, that is often a seasonal effect, where volume tends to diminish over the summer months. With that said, both the primary signal as well as the volume signal generated by Dow Theory are suggesting a potential reversal, as of mid-July.
Dow Theory in context
Critics of Dow Theory (and of technical analysis in general) might say that prices alone are 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 potential Fed moves, inflation trends, and geopolitical developments—overwhelm any value of assessing market psychology via charts.
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. That said, Dow Theory, created by the father of technical analysis, may provide useful insight into this market.