Dow days of summer

Dow Theory, which can help you decide when market moves may have staying power, suggests stock strength right now.

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Amid the winds of change surrounding government policy, the Federal Reserve’s monetary policy, and geopolitical events, U.S. stocks continue to grind higher—thanks mostly to persistently strong earnings growth.

But does the uptrend have staying power? If you like using chart analysis, consider Dow Theory, the foundation of technical analysis created by Charles Dow, cofounder of the Wall Street Journal and the Dow Jones Industrial Average. Currently, Dow Theory suggests U.S. stocks could be poised to go higher.

Dow Theory primer

Much of technical analysis 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 far from being commonly used as they are now. Dow created two 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 fundamental crux of all technical analysis. 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 this: The averages must confirm one another.

For example, suppose that during a hypothetical 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 two 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 the recent time frame), 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. In practice, active investors can use Dow Theory to discern broad market trends.

Dow Theory now says...

The illustration below is a one-year chart of the Dow Jones Industrial Average and the Dow Jones Transportation Average. You can see how, in early November 2016, the averages confirmed one another (i.e., both the Transports and the Industrials moved higher). Subsequently, stocks rallied through the end of February 2017. Then, both averages plateaued and confirmed a modest downtrend that lasted for a few months.

More recently, both the Transports and Industrials bottomed in mid-May, and have jointly rallied through mid-July. The rally has occurred on moderately stronger volume relative to the same period last year. That’s significant because volume typically decreased in the summer months, compared with winter and spring levels. (Note: Due to the seasonal nature of market performance, it is often useful to compare similar time frames when assessing volume trends.)

It is worth noting that, in early July, the Transports increased at a greater pace than the Industrials average. This is a trend you may want to keep an eye on, in the event that the averages do not confirm one another in the near future. Moreover, with stocks at all-time highs, chart users do not have a key price “resistance” level that can be used as a bellwether to gauge if the market has the strength to rise further. Thus, while Dow Theory suggests U.S. stocks have momentum, caution is warranted.

One 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 two 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. Dow Theory, created by the father of technical analysis, can be one of many valuable resources at your disposal.

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