The early days of summer 2016 are shaping up to be anything but lazy. The United Kingdom voted on June 23 to leave the European Union. The Summer Olympics in Brazil kick off in early August. The U.S. presidential race continues to heat up. Plus, investors remain focused on when the U.S. Federal Reserve might change interest rates again.
With so many forces in play, you may want to use all the tools at your disposal to determine which market moves may actually have staying power. If you like using chart analysis, consider using 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 that the market may be searching for direction.
A Dow Theory primer
Much of technical analysis derives from Charles Dow’s findings that markets move in discernable 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, leaving patterns in the sand to show where high and low tides may occur. He believed that, if you can 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 would not become as commonly used as they are now for quite some time. Dow, who was well ahead of his time in terms of how he looked at the overall market, created two indexes (or averages, as they are referred to in Dow Theory): Industrials and 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.
- The market moves in waves.
- Volume must confirm the trend.
- A trend is assumed to exist until evidence suggests it has reversed.
Dow believed that markets are forward looking and that we can observe expected behavior in price action. This is the crux of all technical analysis. “Dow Theory presents an opportunity to take a step back from the day-to-day fluctuations of the market and understand the primary trends,” notes Dave Keller, director of technical research at Fidelity.
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 during a bull rally that the Transports made a new relative high (e.g., a price that is higher than recent data) but the Industrials did not. The fact that the averages did not confirm one another (that is, both did not make new relative highs) may indicate a coming reversal. Consequently, both averages might fall below a significant intermediate support level (see Dow Theory reversal chart).
In addition to Dow’s belief that the movements of the averages must confirm each other, he thought that volume must confirm the trend as well. For example, if a stock rises and volume rises as well, that means volume has confirmed the uptrend. Similarly, if a stock declined 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 Charles Dow's work. In practice, active investors can use Dow Theory to discern broad market trends—which we will illustrate now.
What Dow Theory says now
The chart below is a one-year chart of the Dow Jones Industrial Average and the Dow Jones Transportation Average. You can see how, in November and December of 2015, the averages did not confirm one another (e.g., after both climbed the previous month, the Industrials kept moving higher but the Transports did not). Subsequently, stocks declined in January.
More recently, the Transports weakened dramatically in May, and the Industrials declined as well—but not nearly as much. This divergence may have suggested that the downtrend wasn't strong. Plus, the downtrend in both indexes occurred on relatively weak volume—another sign that the downtrend was not strong from a chart perspective. Since then, stocks have been moving sideways, and on relatively lower volume (which is normal heading into the summer months).
“When the Dow Industrials broke to new closing highs in April 2016, the non-confirmation from the Dow Transports suggested that we could continue to see a trading range,” Keller says. “In my view, the 2015 fourth-quarter levels appear to be the most important now. Until the Dow Industrials close above those highs, with the Dow Transports confirming the breakout, Dow Theory would contend that a new cyclical bull market is unlikely.”
Of course, Dow Theory is only one way that you may try to assess the market. Many seasoned active investors use several tools and methods, including fundamental analysis, to help identify changes in trends. Dow Theory, created by the father of technical analysis, can be another tool at your disposal.
Past performance is no guarantee of future results.
Views expressed are as of the date indicated and may change based on market and other conditions. Unless otherwise noted, the opinions provided are those of the speaker or author, as applicable, and not necessarily those of Fidelity Investments.
Stock markets are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments.
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