Stock signal given by Dow theory

Here's what this indicator says about stocks.

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  • Dow Theory can be used to help determine the market's trend.
  • This indicator suggests there may be reason to be optimistic short term.
  • Key factors to watch continue to be earnings, potential rate hikes, inflation trends, COVID developments, and spillover effects of the war in Ukraine, among others.

At this time last year, stocks were ascending to new all-time highs and COVID developments were the dominant factor helping drive markets. What a difference a year makes. While COVID continues to loom over markets to some extent, stocks are down more than 20% year to date, driven lower primarily by multiple US central bank rate hikes, spiking inflation, and geopolitical unrest from the war in Ukraine. These factors, mixed with relatively resilient corporate earnings, have US stocks—as measured by the S&P 500—trading in a range in recent weeks.

If you are an active investor looking to identify the primary direction that the market may go over the near term and you like using charts to supplement your fundamental analysis of investment ideas, consider utilizing Dow Theory—the foundation of technical analysis created by Charles Dow, cofounder of The Wall Street Journal and the Dow Jones Industrial Average.

Dow Theory suggests there may be reason for optimism over the near term.

What is Dow Theory?

Much of technical analysis—finding patterns and trends based on market behavior and investor psychology—derives from Dow's belief 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.

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 relatively 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 the most recent data, which can be several weeks or months) 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 for 1 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...

The chart below shows how both the Industrials and Transports have trended lower throughout 2022. An interpretation of this year's downtrend could be described as a secondary wave within the context of the larger uptrend.

More recently, the Industrials and Transports have made some lower lows and higher highs—albeit not consecutively in both cases. For the averages to confirm one another, a continuation of this trend might be a signal that bullish sentiment is strengthening over the short term.

The volume picture is less clear. Generally, volume has been soft, 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 confirm any existing trends or potential reversals. Traders utilizing Dow Theory would want to confirm any bullish move with the presence of increasing volume.

Dow Theory in context

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.

More importantly, signals given by Dow Theory and other indicators may be rendered irrelevant when powerful market events—like Fed rate hikes, inflation trends, geopolitical developments, and COVID effects—overwhelm any value of assessing underlying market psychology through price action.

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. With that said, Dow Theory, created by the father of technical analysis, may provide useful insight into this market.

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