What is the Dow Theory?
The Dow Theory is a financial theory developed by Charles Dow. He was the founder of Dow Jones and Company and the editor of the Wall Street Journal. Dow believed the stock market is a reliable measure of the overall business conditions of the economy. By studying the stock market, it is possible to gauge the health of the U.S. economy and, most importantly, identify the longer-term trends in stocks.
In theory, it tries to find patterns and trends based on market behavior and investor psychology. Dow Theory applies the principle of confirmations to confirm primary trends. Charles Dow believed the Dow Industrials and the Transports can confirm the underlining trend of the broader market. The theory stipulates the market is strong or in an uptrend (bullish) when the Dow Jones Industrial Average (INDU) and the Dow Jones Transportation Average (TRAN) both advance above their previous highs. For instance, if INDU records a new all-time high, TRAN should also follow suit with a new all-time high.
How does the Dow Theory work?
The basis of the Dow Theory is predicated on the following: The market discounts everything. It is forward-looking. The market tends to move in trends. There are three primary kinds of market trends (primary, secondary, and minor). The primary trends consist of three phases (accumulation, public participation, and speculative/excess). and confirmations. Indexes must confirm each other. For example, market indexes such as INDU and TRAN need to confirm one another in price and volume patterns to validate the primary trend. A non-confirmation or divergence occurs when one average falls short by not confirming a higher-high. Volume should confirm the primary trend. When the price is in a primary uptrend, the volume should increase as the price rises. A primary uptrend tends to continue until a reversal occurs.
Dow Theory and the Economy
Since the stock market is a proxy for the overall business cycle, when the Dow Transportation Average (TRAN) and the Dow Industrial Average (INDU) breakout to new all-time highs, this is a good sign of a robust economy. After all, the stock market is one of the leading economic indicators. Industrials produced capital goods used in construction and manufacturing. Transports are involved in the shipments of goods. When both are performing well, it bodes well for the sustainability of the primary bull trend.
Confirmation of primary trends is critical to sustainable primary trends. However, a negative divergence between two markets can also warn of an impending reversal.
Dow Jones Composite Average = Dow Jones Industrial + Dow Jones Transportation + Dow Jones Utility
Dow Jones Composite Average is comprised of the 65 companies from the Dow Jones Industrial, the Dow Jones Transportation, and the Dow Jones Utility averages. The three major Dow averages provide a broad measure of the activities of the U.S. economy. Although this may be true when Charles Dow first introduced the Dow Theory, it is not necessarily the case today. The current U.S. economy has revolved into a service-dominated economy where industries such as Technology, Healthcare, and Finance have become increasingly influential to the U.S. economy. Nonetheless, the Dow Theory has stood the test of time and remains a worthy investment theory for any investor.
Is the Dow Theory Confirming the Primary Bull Trend?
The Dow Jones Industrial Composite Average (DJA), the Dow Jones Industrial Average (INDU), and the Dow Jones Transportation Average (TRAN) have all confirmed new all-time highs via V-pattern breakouts late last year. The above bode well for the recovery of the U.S. economy and the sustainability of the current stock market bull trend.
Only one Dow Jones Average failed to record new all-time highs. It is the Dow Jones Utility Average (UTIL). Above the Feb/Nov 2020 highs at 931.30-963.80 would validate new all-time highs. Although a non-confirmation is a warning, it may not be an ominous sign since UTIL is a defensive index. The lower-highs and higher-lows could also turn into a bullish symmetrical triangle.
The V-pattern breakouts are technically significant patterns. The Dow Jones Composite Average clearing above 9,727.42 suggests +3,754.22 or a technical target of 13,482. For INDU, a breakout above 29,558.57 renders +11,355 or a projection of 40,923.5. TRAN's surge above 11,623.58 hints at +5,142.38 or a target of 16,766.
The close correlations between the four DOW Averages are also noteworthy. For example, INDU and TRAN have a current direct correlation of 0.95. Between INDU and DJA it is currently at 0.99. Also, the INDU and SPX correlation are remarkably close at 0.98. Even the correlation between INDU and the more volatile and technology-heavy COMPQ is at 0.90. However, the correlation between INDU and UTIL is only at 0.38, suggesting the Dow Utility Average and Dow Jones Industrial Average do not trade in sympathy with one another, at least over the past 3-plus years.
Although consolidations and corrections can occur within primary uptrends, when the DOW Transports, Industrials, and Composite set new all-time highs via higher-highs this confirms the Dow Theory buy signal. It sends a powerful message – the U.S. economy is healthy, and the stock market bull trend will continue for a while longer.