Dow days of summer

Dow Theory suggests stocks could strengthen, but not all signs are positive.

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  • This technical analysis theory created by Charles Dow, founder of the Dow Jones and Wall Street Journal, suggests US stocks might rally.
  • However, more volume is needed to confirm the trend.
  • Technical patterns like Dow Theory can supplement the economic and fundamental factors shaping market direction.

Measured by volume alone, this summer’s stock market has been in the doldrums. But price action has hardly been calm, thanks to turbulence in Turkey, major volatility in several leading tech stocks, and more central bank tightening on the horizon. With that said, the underlying force driving markets, including the US, has been persistently strong corporate earnings, helping drive stock prices back toward the top of 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 may be poised to go higher, though one key ingredient is missing from this indicator saying the market might really start cooking.

Dow Theory primer

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 the long-term primary uptrend for US stocks. While there was a sharp correction in early 2018, followed by a multi-month period where stocks moved mostly sideways, stocks have resumed their uptrend more recently.

Over the past month or so, both the Industrials and Transports have been making higher lows and higher highs—a bullish signal according to Dow Theory. Of note, there was a moderate correction in July that pushed both averages lower than prior lows. Yet the Industrials and Transports have made several higher highs since then, including in early August where stocks have moved within striking distance of their record highs set in January 2018.

With that said, volume for both averages has been low relative to prior months—as the Dow Jones Industrial Average volume depicted on the bottom of the chart reveals. Recall that Dow believed volume must confirm the trend. Thus, while the averages have confirmed one another’s uptrend, volume has not increased commensurately.

If volume picks up, as it historically does when the calendar turns from August to September, and the averages continue to confirm one another’s uptrend, that would be a buy signal, according to Dow Theory. If volume does not increase relative to its current level, along with the averages making higher highs and higher lows, this would be a sign that the market may not continue to move higher. (Note: Due to the seasonal nature of market performance, it is often useful to compare similar time frames when assessing volume trends).

Stocks are reapproaching all-time highs, so chart users have a key price resistance level that can be used as a bellwether to gauge if the market has the strength to rise further. In sum, Dow Theory suggests US stocks have potential upward momentum, but caution is warranted.

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.

Next steps to consider

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