- This indicator suggests the bullish trend could continue, but there’s a trend to watch out for.
- Dow Theory uses 2 key indexes to help determine the market’s trend.
- In addition to chart trends, investors can monitor key fundamentals like earnings, additional rate hikes, inflation trends, and other factors to gauge the market.
The Dow Jones Industrial Average—which represents 30 of the biggest and most influential US companies—has gained roughly 7% this year on a price return basis, as of late July. That’s a turnaround from last year (when the Dow lost 7%). Moreover, the Dow is at a more than 15-month high and set a record in July by gaining 13 consecutive days, matching the index’s longest such streak set in 1987.
Still, the Dow's gain lags the roughly 20% year-to-date surge for the S&P 500 and more than 35% rally for the tech-heavy Nasdaq. Moreover, low market breadth (where a relatively small percentage of stocks have been outperforming the market while the rest underperform) has some investors wondering about the strength of the rally, in addition to other worries—including more rate hikes from the US central bank and a potential recession.
In this context, here's what Dow Theory says about stocks.
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, and both averages have recently made new 52-week highs. It would appear that the averages are confirming one another, and chart users would interpret this as the bullish trend having momentum to continue.
It is worth noting that the Transports have far outperformed the Industrials this year—a development that could be worth watching. If either index fails to continue to make higher highs, that might be evidence of a potential reversal.
The volume picture also has some nuance. Generally, volume has been relatively soft in recent months, but that is often the seasonal effect this time of year where volume tends to diminish over the summer months. Consequently, volume does not appear to indicate a potential reversal. With this said, the primary signal generated by Dow Theory, as of late July, is for a continuation of the existing uptrend.
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 the recent Fed rate hike, 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.