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Dow days of summer: Watch the blue chips.

How to use one of the first technical theories to help forecast the market’s next move.

  • Fidelity Active Trader News
  • – 08/20/2014
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If you use technical analysis, you have Charles Dow—cofounder of the Wall Street Journal and Dow Jones Industrial Average—to thank. He created the principles of “Dow theory,” a foundation of modern technical analysis, which is still valid today.

Even though the market weakened a bit in early August, it has since rebounded, and the long-term uptrend may still be intact, according to Dow theory.

Why is Dow theory important? Can it help you trade?

All technical analysis derives from Charles Dow’s findings that markets move in trends, and that these trends are discernable. 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 water crashes onto the beach, leaving patterns in the sand to show where high and low tides may occur. Quite obviously, if you can identify the direction of market trends, you may be able to better position your portfolio.

Dow theory primer

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 primary trend is inviolate.
  • The averages discount everything.
  • The theory is not infallible.

“The primary trend is inviolate” refers to the idea that the general direction of the market is not determined by the actions of big participants, but rather by the natural movements of the market as a whole.

The most relevant aspect of Dow theory is his assertion that “the averages discount everything,” with the market moving in waves (see sidebar). Dow thought that market moves could be forecasted because the movement of the averages (or indexes, as we now more commonly refer to them) included expectations for the future. This idea, that markets are forward looking and we can observe expected behavior in price action, is the crux of all technical analysis.

Dow theory in action

If there is one critical thing to know about Dow theory, it is this: the averages must confirm one another. For example, suppose during a bull rally that the Transports made a new relative high, 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 reversal. Consequently, both averages might fall below a significant intermediate support level (see chart below).

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. He assumed an existing trend to be in place until clear signals, confirmed by volume, indicated that it has reversed.

What Dow theory says now

With stocks moving sideways over the last several weeks, Dow theory may be able to help you determine whether the long-term uptrend is weakening. According to Mark Dibble, senior technical analyst at Fidelity, Dow theory suggests the uptrend is still intact.

“The Dow Jones Industrial and Transportation Averages made new, simultaneous, all-time highs in mid-July 2014. Thus, Dow theory remains bullish on the primary trend,” Dibble says. “Dow theory has actually been giving investors a green light since December 2012—when the Transports broke out of an 11-month trading range (see the chart below).”

However, Dibble notes that there are reasons to potentially question the strength of the signals being given by Dow theory. “Despite the Dow theory buy signal,” Dibble explains, “the Industrial Average has lagged the S&P 500 in 2014,” which may suggest some weakness in the bullish Dow theory signal.

However, Dibble says, “Some of this underperformance can be explained by the anachronistic price weighting of the Dow averages (it is a price-weighted index that does not account for the number of shares of a company and its relative size), in combination with a major rebalancing of the Industrials in September 2013. For instance, the Dow Jones Industrial Average added Goldman Sachs (GS), Nike (NKE), and Visa (V), and these recent additions have lagged the broader market.”

Investing implications

Assuming the current, bullish Dow theory signal is correct, long positions might remain attractive. If stocks do exhibit additional weakness in the coming weeks and months, you can look to the averages for the possibility of a reversal of the existing longer-term uptrend.

Of course, Dow theory is one more way that you may try to assess the market. Many technical analysts use several tools and methods, including fundamental analysis, to help spot changes in trends. Dow theory, created by the father of technical analysis, can be another tool at your disposal.

Learn more

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Technical analysis focuses on market action—specifically, volume and price. Technical analysis is only one approach to analyzing stocks. When considering which stocks to buy or sell, you should use the approach that you’re most comfortable with. As with all your investments, you must make your own determination as to whether an investment in any particular security or securities is right for you based on your investment objectives, risk tolerance, and financial situation.

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.

These comments should not be viewed as a recommendation for or against any particular security or trading strategy. Views and opinions are subject to change at any time based on market and other conditions.

Stock markets are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments.

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