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Is Dow Theory Still Relevant?

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I got a SUBSCRIBER E-MAIL asking me if I thought that Dow Theory was still useful in seeing the big market picture here at this juncture. Especially since the Dow Transportation Average (TRAN) has been so STRONG relative to the Dow 30 Industrials (INDU).

RESPONSE: Well, Dow Theory is mostly relevant to an investment oriented time frame; that is, determining the long-term year or over year trend as up or down. This is less relevant to options traders although most of us also have long-term equities holdings, especially in retirement accounts. However, it is useful to have some definition of whether the current market is a bull or bear market.

While I don't consider myself an expert on all nuances of Dow Theory, I find it very instructive to look at what the Dow Transports are doing relative to the Dow 30. Once in a while there is a STRONG indication to go more heavily into puts or calls from the RELATIVE action of the two averages.

By the way, this market has to be still considered a bull market in terms of Dow Theory. However, INDU has not made it to a new closing weekly high unlike TRAN, which did so long ago. This divergent action is, to date, a non-confirmation of the primary UP trend dating from late-2002/early-2003. At some point this year the Industrials should exceed its 1999 weekly closing high at 11,723 to suggest that that the primary market trend remains up.

Of course, since we now have two markets now so to speak, NYSE and Nasdaq and with the tech-heavy Nasdaq Composite (COMP) and even the S&P 500 (SPX), so far below their prior weekly closing highs, it does seem like we are in a new world and have left Charles Dow way back in the last century; COMP has retraced only 31% of prior decline only! SPX has regained 72% of what it lost from its 2000 peak to its 2002 low.

BEFORE CONTINUING ON DOW THEORY, ONE OTHER NOTE:

My INDEX TRADER articles:
This Wednesday Trader's Corner article also serves as an adjunct to my weekend 'Index Trader' column, an online (only) section at the Option Investor.com web site; you can bookmark this section or add to your 'favorites' by clicking HERE.

I wrote in my weekend Index Trader ("Into the Doldrums") that it looked more likely for the market to drift sideways to lower, (perhaps re-testing the lows) than break out above technical resistance; the initial/first rebound off the lows took the major indexes back to, not above, technical resistances.

In my Wednesday Trader's Corner articles I typically also work in a technical midweek update to my weekend Index Trader. Especially so when I can demonstrate the relevant technical/trader tools discussed here.

You will normally also see a web LINK to the Index Trader at the top of your weekend Option Investor Daily e-mail but was NOT the case for my most recent article of Sunday (4/30). This column can be seen by going to our web site using the above LINK; when connected to the Internet of course.

DOW THEORY CONTINUED:

What came to be known as "Dow Theory" and Charles Dow didn't call it that, it was simply a body of market 'observations', is not a system of market timing but more of a forecaster of the major or 'primary' trend (over many months and often years)and tends to predict economic downturns or recessions.

Back in the 1880s and 1890s, Charles Dow, who, along with Edward Jones formed Dow Jones & Co. (discloser: I worked for Dow Jones in the 90's), came up with the first stock
market averages, which became, over time, the Dow Jones Industrials (now 30 stocks) and the Transportation average (Symbol: TRAN and now 20 stocks) as well as a Utility stock average (now 15 stocks).

I tend to call the Dow Industrials, the 'Dow 30' as these 30 stocks have become more technological, communication, manufacturing and service oriented and less of what we think of as 'industrial', unlike the case of the heavy industry stocks like U.S. Steel that were part of the early Dow.

One of Dow's most important contributions was the idea that 'confirmation' of the primary trend occurs by the actions of BOTH the Industrial and Transportation averages. A related aspect to this, really the flip side of it - is the concept of 'divergence'.

Dow spoke mostly about confirmation divergences between averages and between prices and volume or between price action and indicators is mostly what came in this century by various technical analysts.

Dow said that if the Dow 30 Industrials (INDU) moved to a new closing high or low, without the Transportation average following suit at some point (within a few months usually) and failed to 'confirm' the new high or low or, if the Transportation Average (TRAN) goes to a new peak or new low, without the same action in the Industrials we should be on alert for a possible change or reversal of the primary trend.

If production is slowing, there may not be a slowing of production for a while as companies let inventories build up and we see little initial change in what the stocks of the Dow Industrial average are doing. However, the transportation companies will tend to see a slowdown in shipments more immediately and the Transport stocks start to slide; or, not go on to make yet another high.

If the Industrial companies see a pick up in orders when the economy turns up, they may work off inventory first, BEFORE we see a pick up in their earnings due to advance sales, whereas the transportation companies will tend to see a pick up in orders immediately. These are some of the ways that one average can go its own way, with the comparative difference in price action offering key tip offs at times to what is happening in the economy.

LAST MAJOR LOWS

The Dow Transportation Average (TRAN) made a new closing low in early-2003 as shown on the upper TRAN portion of the chart above, whereas the Dow 30 (INDU) make a higher low around the same period. INDU did not 'confirm' TRAN in its new low, generating a quite useful Dow buy 'signal'. At this time, inventories were low and as the companies ramped up production, the knowledgeable or savvy investors started doing some buying in the those stocks keeping the Average providing some good underlying support.

This Dow Theory 'non-confirmation' or bullish divergence, the fact that INDU turned made a higher relative low, was a helpful 'signal' to do some significant buying; buyers of DJX calls that bought heavily on that 'signal' did very well during that period. And market 'sentiment' was quite bearish during this period, which was another thing that Charles Dow first said was typical of the first lift off from a bear market.

The predominance of bearish readings (heavy put buying relative to calls) is shown graphically in my Call/Put Sentiment indicator seen under the S&P 100 (OEX) chart below, that is of the price history for early-2003. The Dow of course was in the same kind of very strong and steep advance as OEX.

That first very strong advance, armed with the knowledge of the Dow Theory buy signal, made my year in terms of index option profits. I don't believe in always buying at the same 'level'. There are just a few times in a year where there are compelling index option buy opportunities but a select number of those (e.g., 1-2) are worth trading as heavy as is still reasonably prudent relative to the money you have to trade with.

A failure to make a new high or low in the EITHER average that WAS made by the other Average, is sometimes if not often a good indication for a major turning point in the market.

CURRENT CASE

The Dow 30 Industrials (INDU) filed to make a new closing weekly high recently and has retreated sharply since then. Is this the REVERSE of the early-2003 situation and 'signaling' the start of a major downtrend in the months ahead? Perhaps. What else to watch for that would be 'benchmark' technical milestones? (The below chart was run when INDU was up a bit more than it was on the close +51.8, versus +48.8 at today's close.)

For one, I'm watching to see if the 'line' of prior closing weekly highs around 10,980-11,000 is pierced; this horizontal dashed line is seen on the lowermost chart of INDU below.

Major other benchmarks in terms of the primary trend, would be if the long-term up trendline was pierced, which intersects currently in the 10,500 area, which is where that green up arrow is under the trendline above.

The other major reference point technically on the Weekly Dow chart above is the prior closing weekly low at 10,215 from last year (late-2005). A weekly close under this level confirms a reversal of the primary trend.

In my 'Essential Technical Analysis' book I used an example of a major blockbuster type Dow signal that could have put anyone on the right track in terms of getting into stocks big time as a new low in the Transports was NOT confirmed by a new low in the Industrials, as seen on my last chart below:

When the lows were made in INDU, we can assume that manufacturing was holding relatively steady; there was probably not much of a build up of inventories. But, transportation stocks were suffering more relative to the heavy volume and good earnings that they were experiencing in the prior year(s).

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