The Dow Theory is one of the oldest investment strategies in existence and is widely followed by many market participants. After all it was created by the father of technical analysis, and the principles of the Dow Theory is the foundation for most of the technical investment disciplines currently deployed in today’s marketplace.
Charles H. Dow, co-founder of Dow Jones & Company, Inc. and the first editor of Wall Street Journal, created the Dow Theory in the late-19th century. The Dow Theory is based on the collective writings of Charles Dow. The premise of this 100-year old theory is that tracking the performances of Dow Jones Industrial Average (INDU) and Dow Jones Transportation Average (TRAN) can help gauge the sustainability of future market trends.
A Dow Theory sell signal occurs when both Dow Jones Industrial Average and Dow Transportation Average close at a lower-low pattern after recording a lower-high formation. If either of the averages diverge from one another then it warns of a sideways trading range environment, an impending market correction or worse, the start of the next bear decline. For instance, Dow Industrials records a higher-high formation via new all-time highs, but Dow Transports records a lower-high formation and subsequently declines below its prior reaction low thereby confirming a lower-low trend.
Charles Dow believed that the stock market is as good a proxy as any to measure the overall business conditions of an economy. By carefully analyzing Dow Jones Industrials, Dow Jones Transports and their components an investor can gauge the direction of major market trends. This may have work well during the turn of the century and into the mid-1900s when the stocks in the Dow Jones Industrials and Dow Transportation dominate the US economy.
However, as the US transitioned from an agricultural economy to manufacturing, and now to a service driven economy we believe Dow Jones Industrials and Dow Jones Transportation may not be as an effective proxy for the US economy as in the past.
Today the US GDP is heavily weighted toward the service sector as 77% comes from service, 19% from the industry sector, and 1% from the agriculture sector. A better Dow Theory in today’s service driven economy is to compare two of the most important service driven market indexes - S&P 500 Index (SPX) and NASDAQ Composite Index (COMPQ) in lieu of Dow Industrials and Dow Transports.
The higher-highs and record highs from SPX and COMPQ is in sharp contrast to the negative divergences developing between INDU and TRAN. Based on the new Dow Theory this would imply the current bull trend still has legs and is sustainable.