Build a Better Mousetrap - Old versus New Dow Theories
A Better Mousetrap
American essayist and philosopher Ralph Waldo Emerson first coined the phrase: “Build a better mousetrap, and the world will beat a path to your door.” One of the great American thinkers of the 19th century suggests that to invent the next important thing, you need to have a better idea, and hence a better mousetrap. The phrase has turned into a metaphor, describing the power of innovation and the need to improve an existing and widely used product or service.
The Original Charles Dow Theory
The Dow Theory has been one of the most successful investment disciplines for traders and investors. Its principles help one better understand the stock market and identify future price trends and actions.
The Dow Theory remains one of the oldest investment strategies and continues to be widely followed by many market participants. It was created by the father of technical analysis. Even today, many of the principles of the Dow Theory remain the core foundation for most of the technical investment disciplines.
The Dow Theory is based on the collective writings of Charles Dow, the co-founder of Dow Jones & Company and the first editor of the Wall Street Journal. The premise of the 100-year-old theory is by studying the Dow Jones Industrial Average (INDU) and Dow Jones Transportation Average (TRAN) one can better gauge the health of the economy and the direction of future market trends.
Dow Jones Industrial Average and Dow Transportation Average
The basic Dow Theory states that to have sustainable and longer-lasting uptrends, the Dow Jones Industrial Average and Dow Transportation Average should confirm each other. When one average record a new all-time high (i.e., higher-high pattern), the other average should also record a new all-time high. Any divergence between the two warns of either the start of a consolidation phase or an impending trend reversal. For instance, Dow Industrials records a new all-time high via a higher-high pattern. However, Dow Transports does not and records a lower-high formation. The lack of follow-through to new all-time highs warns of an impending trend reversal. When the Transports declines below its prior reaction low via a lower-low, this confirms a trend reversal.
Charles Dow believed the stock market is as good a proxy as any to measure the overall business conditions of the U.S. economy. By studying the Dow Jones Industrials and the Dow Jones Transports, investors can better understand the internal health of the economy and the direction of future stock market trends.
Today's Service-Driven Economy
The Dow Theory may have worked well in the past when industrial and transportation stocks dominated the economy. However, as the U.S. economy pivot from an agricultural to manufacturing economy, and now to a service-driven economy, the Dow Jones Industrials and Dow Jones Transportation may not be as effective as in the past.
The U.S. GDP is comprised of four components, including personal consumption expenditures, business investment, government spending, and net exports of goods and services. Today, the US GDP is heavily weighted toward consumer spending as this component comprises over 70% of the overall total. 77% comes from service sectors, 19% from the industry sector, and 1% from the agriculture sector.
A better mousetrap is to create a better Dow Theory. In today’s service-driven economy, it seems that the two most influential market indexes - the blue-chip S&P 500 Index (SPX) and the growth-dominated NASDAQ Composite Index (COMPQ) may be a better reflection of the current service-driven U.S. economy.
So, what are the charts saying about the old and the new Dow Theories?
The Old Dow Theory (INDU versus TRAN)
Dow Jones Industrial Average (INDU - 35,741.15) is currently trading slightly above 35,631.19 or the 8/16/21 all-time closing high. A new record high confirms a higher-high formation and completes a 5-month ascending triangle breakout. The breakout suggests 2,359.26 points or the next sustainable INDU rally toward 37,990.5.
Dow Jones Transportation Average (TRAN - 15,874.27) lagged Dow Industrials (INDU) from May to Sep 2021, as it recorded a lower-low pattern. However, since the 9/20/21 low (13,946.86), TRAN has surged higher, outperforming its Dow peer. A convincing move above 15,943. (5/10/21 all-time high) confirm a record high.
Based on the old Dow Theory, if TRAN does not set new highs and suffers a lower-low 2021, this warns of a market correction, or worst, the start of the next bear market. On the other hand, a new all-time high confirms another technical breakout, rendering 1,942.52 points to a TRAN target at 17,886.
In summary, the old Dow Theory is nearing a critical juncture. If INDU maintains its breakout and TRAN records a new all-time high, this reaffirms a robust economy and the start of the next stock market rally.
The New Dow Theory (SPX versus COMPQ)
The S&P 500 Index (SPX - 4,566.48) has cleared the prior all-time closing high of 4,536.95 (9/2/21). The breakout and a higher-high pattern hint at another 236.49 points or an SPX target at 4,773.
The Nasdaq Composite Index (COMPQ - 15,226.71) has lagged the SPX Index over the past couple of months. However, a convincing move above its 9/7/21 closing all-time high of 15,374.33 confirms a higher-high pattern. The breakout suggests another 1,119.85 points or a COMPQ target at 16,493.
Whether the New Dow Theory is more dependable than the old Dow Theory in today’s service-driven economy is debatable. Nonetheless, the technical confirmations or divergences between the indexes and averages remain an integral part of any Dow Theory. COMPQ and TRAN have both lagged their counterparts, SPX and INDU. However, the laggards can still catch up to their peers via technical breakouts above their respective all-time closing highs. In the meantime, we recommend investors and traders monitor both Dow Theories for divergences as well as confirmations.