Dow Theory

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Dow Theory: The Most Important And Powerful Concept In Technical Analysis

by Jim Stanton, Contributing Editor
Friday, October 13, 2006: Issue #362

Over 100 years ago, Charles Dow came up with the foundation for what would become the most powerful and commonly-used investment theories. But it was actually his understudy, Wall Street Journal editor William Hamilton, who refined and expanded the concept.

I’m talking about Dow Theory. And being a professional technical analyst for about 25 years, it’s something that has always fascinated me, since it’s one of the oldest and most reliable intermediate- to long-term chart patterns.

Simply put, Dow Theory states that both the Dow Jones Industrial Average and Dow Jones Transportation Index have to make higher highs together in order for a bull market to stay intact. The same goes for a bear market – both indexes have to make lower lows around the same time in order for a bear market to continue. When one index does not confirm the other, within a reasonable amount of time, there is a good chance for a reversal in both indexes.

Since my technical specialty is “pattern recognition,” Dow Theory obviously forms a critical part of my overall analysis. And what that analysis is telling me right now is that some interesting changes could be around the corner…

Dow Theory: Accept No Imitations… Always Follow The Leader

Recently, numerous traders have tried to dilute the Dow Theory down to a “system,” whereby a series of confirmations in both indexes is taken to be “buy” or “sell” signals. But this neglects other important factors such as valuation, economic conditions, and investor sentiment.

Steer clear of this rather simplistic analysis. The key to Dow Theory is that you have to give the “lagging index” time to catch up with the leading index. If the Transports make new highs and the Industrials do not, you have to give it some time to “catch up” and/or wait for some kind of sell signal on the Industrials before declaring that a Dow Theory sell signal has been triggered. Let me give you an example…

Back in January 2000, the Dow Industrials hit a top. But the Transports didn’t follow suit, and the move wasn’t confirmed. Result? We got a 3-year bear market that eventually ended in March 2003 when the Transports made new lows. Again, we knew the bear market had ended, because Dow Industrials didn’t copy the Transports’ low.

If a market is showing signs of a potential reversal, I use Dow Theory as a “confirmation” tool that proves to be very valuable in my analysis. And what I’m looking at now shows that there is a potential Dow Theory signal setting up, as the Industrials have hit new all-time highs, while the Transports and many of the other indexes are lagging behind.

So what’s the deal here?

Transports Edging Back Towards Crucial Fibonacci Level

Back on May 10, the Transports hit a high of 5,038.58 – but right now, the index needs to rally almost 10% to reach new highs and confirm the bull market. And while a 10% jump would be a tall order, I’ve seen stranger things happen over my many years analyzing the markets.

My analysis indicates that the next major upward resistance level for the Industrials is around 12,050, which is only 102 points above current levels (the Dow rose 96 points yesterday and carved out another new record high of 11,959.63 in the process).

The chart below shows a daily chart of the Dow Transports, which, as you can see, is approaching the crucial 62% Fibonacci retracement level (4,860) set during the May-August correction. From current levels, that would be about a 2% move.

Chart Courtesy of Trade Navigator Software: http://www.genesisft.com

Setting Up For A Sell Signal?

What I conclude from this analysis is that, while the bulls shouldn’t be too concerned, some caution is warranted.

If the Industrials reach the 12,030 to 12,050 level, and the Transports continue to lag, a Dow Theory sell signal could occur. BUT… we would need to allow time for the Transports to play catch up, or trigger a sell signal.

Keep a close eye on the various Nasdaq indexes, too. They are only about 3% to 4.5% below this year’s highs, and if they make new highs for the year, the Transports may have more time to confirm the Industrials. Of course, if a Dow Theory signal looks imminent, I’ll keep you posted right here.

Good Trading,

Jim Stanton