Trouble sign for stocks: Dow Theory

This indicator suggests stocks have a hurdle to clear in order to rally.

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  • A warning sign is being given by Dow Theory.
  • However, if stocks were to clear a hurdle, this indicator would produce a bullish signal.
  • Technical patterns like Dow Theory can supplement the economic and fundamental factors shaping market direction.
 

There have been many reasons to think the bullish momentum behind stocks might slow or reverse. Factors like the lingering US-China trade war, slow global growth, and tough comparables. Yet the underlying force driving markets, including the US, has been persistently strong corporate earnings, helping drive stock prices back toward new all-time highs on their charts.

If you like using charts to supplement your fundamental analysis of investment ideas, consider 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 have an important price level that needs to be cleared before the rally continues.

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 recent data) 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 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...

The first thing that should be apparent in the 1-year chart below of the Dow Jones Industrial Average and the Dow Jones Transportation Average is that stocks—while now at all-time highs—have been trading in a range, for the most part, over the past 12 months. Additionally, the Industrials and Transports have been trading similarly, with a notable recent exception.

A cause for concern for stocks right now, based on Dow Theory, is that—even though the Industrials have reached new all-time highs—the Transports have not. In fact, the transports, have yet to make higher highs compared with their April highs, as of mid July. This divergence could be considered a bearish signal for the broad market, implying that the stock rally does not have the strength to sustain itself. However, if the Transports do rally to new highs to join the Industrials, that would be a bullish signal for the broad market.

Another cause for concern is that volume has not increased commensurately with the stock rally. Indeed volume for both averages has been lower relative to prior months as well as year-over-year—as the Dow Jones Industrial Average volume depicted on the bottom of the chart reveals. Recall that Dow believed volume must confirm the trend. Note that, due to the seasonal nature of market performance, it is often best to compare similar time frames when assessing volume trends.

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.

That's why active investors would be wise to bolster their use of Dow Theory with other tools and methods, including fundamental analysis, to help identify trends and potential changes in trends. Nevertheless, Dow Theory, created by the father of technical analysis, can be one of many resources at your disposal.

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