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Dow Theory Today

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Someone wrote me the other day and asked about the current bull market in terms of Dow Theory and if (in terms of this theory) the major market outlook remains bullish. Oh, and by the way, "does Dow theory say anything about what levels could be reached?" NO, to this latter part of the question.

I do keep track of the two Dow Averages, the Transports and the Dow Industrials from week to week, month to month, especially where one of the Averages makes a new advancing high (or declining low) on a weekly or monthly closing basis. However, the aspects of the market that relate to Dow's original work is VERY long-term and 'investment' oriented: the year over year outlook as opposed to week to week or month to month which is what us options traders are so eager to ascertain. Just tell me the week's close on Monday and I'll be happy!!!

However, since most if not all of shorter-horizon traders also have long-term investments in stocks, it's interesting from time to time to look at the BIG picture. And Charles Dow was a big-picture market observer. By the way, Charles Dow's descendents, or Edward Jones' didn't end up owning Dow Jones & Co. This honor went to the Bancroft family who, as a group, just turned down an offer for the company from Rupert Murdoch's News Corp. This offer may or may not mean that the family will end up instead selling to the 'right sort', that being someone other than Mr. Murdoch; perhaps someone that is perceived as having more lofty journalistic principles. And the Dow Jones' flagship Wall Street Journal is sure near the top in terms of their reporting and quality of their stories. When I worked for Dow Jones I was asked, in terms of writing an article about Dow Theory for an internally produced customer magazine ("Markets"), whether it (the article) would reflect well on Dow Jones. Hey, this is a Tony outfit and very button down! I could tell you stories about that but won't!!

I started to write this article last week and got flight delayed on my way to NYC and to connect with some old ties to the Street of Dreams. Actually, today so much stock volume is controlled by the hedge funds scattered around the country in physical location, that it's hard to locate the epicenter of the financial world as being in lower Manhattan anymore. But the New York Stock Exchange is still there; it didn't succumb back when to the New Jersey siren call (gasp!) to move across the river. However, back around the turn of the last century, Wall Street certainly was the center of at least the U.S. financial universe and Charles Dow plied his reporter's beat there.

Its important to understand that Charles Dow considered his ideas on the market (he didnt call it a 'theory' at all) to be the broad strokes and provide the big picture for INVESTMENT purposes only. He used closing prices only and a monthly close at that; rather than on a daily or weekly basis. Ill get to how he expected the averages to behave relative to each other next. Let me start with a current look at the two weekly charts, one on top of the other, of the Dow Jones Transportation Average and the Dow Jones Industrial Average. By the way, my TradeStation software mislabels each Average as an 'Index' which, unlike the S&P 500 Index, they are not. Both are arithmetic (price) averages of the 30 stocks of INDU and 20 of TRAN; neither are capitalization-weighted.

I'll get back to the notations I've made on the chart above shortly. Dow Theory is not a system of market timing exactly, only a forecaster of the major or 'primary' trend (over years, not months or weeks) and a good forecaster of the deeper recessions. Of course there has not been more than a relatively mild recession for a long time.

Back in the 1880s and 1890s, Charles Dow (who, along with Edward Jones formed Dow Jones & Co.) came up with the first stock market averages, which became, over time, the Dow Jones 30 Industrial, 20 Transportation and 15 Utility stock averages as known today. I tend to call the Dow Industrials (INDU) the 'Dow 30' as these stocks have become more technological, manufacturing and service oriented and less industrial, unlike the case of the heavy industry stocks like U.S. Steel that were part of the early Dow Jones Industrial Average.

Today the common term by traders is 'the Dow', or the 'Dow Jones' for the Industrial average. This average of 30 stocks is not capitalization weighted, as is the case of the Standard and Poor 500 or Nasdaq Composite index. Dow stocks of companies that have become price laggards, even if theyre much smaller companies than say General Electric, can have more of a dragging effect in the PRICE weighted Dow 30 average than indexes that give more weight to the larger companies with far more shares outstanding; e.g., the S&P 500(SPX). Conversely of course, stocks in the Dow that soar can put INDU to a new all-time high way ahead of the S&P, which is the case currently.

Only the Dow Industrials and Dow Transportation (TRAN) Averages are used in what became known as 'Dow theory'. Charles Dow as I noted earlier called the market principles he wrote about OBSERVATIONS on how the economy and the market functioned. Dows principles were later discussed in a book by William Hamilton called "The Wall Street Barometer"; Hamilton was the Wall Street Journal Editor that came after Dow. Robert Rhea is credited with distilling the ideas of Dow further and wrote a book in the early-30s called "Dow Theory".

One of Dow's most important contributions was the idea that 'confirmation' of the primary trend must exist by the actions of BOTH the Industrial and Transportation averages. A related aspect to this, really the flip side of it so to speak, is the concept of 'divergence'. Charles Dow spoke mostly about confirmation; use of the term 'divergence' as between averages and between prices and volume or, between price action and technical indicators, is mostly what came along in the 20th century as formulated by various technical analysts.

Dow said that if the Industrials moved to a new closing high or low, without the Transportation average following suit at some point ('confirming' the other Average), or if the Transports went to a new peak or bottom without the same action in the Industrials, no change in the primary trend was suggested. The two averages need to have the same action as far as new highs or lows (to be in synch) otherwise a potential REVERSAL of the primary trend could be in the offing.

The rationale regarding the two averages confirming each other is simple in hindsight, but accounted for a very astute observation on Dows part. For example, industrial or manufacturing activity could continue to be very strong for a period of time while orders for those goods were slowing. This would result in the build up of inventories and an eventual slow down in the economy and in stocks. Where such a slowdown in manufacturing orders would show up FIRST is in transportation orders and activity. Slowing orders in the transportation sector, as fewer goods were shipped, would result in a fall off of those companies' revenues. Astute followers of these stocks would notice this and selling would start to show up in these stocks, either keeping a 'lid' on stock prices or actually driving them lower.

Conversely, manufacturing could start picking up but might not be at first reflected in a pick up in those stocks especially when inventories were being worked down first. However, an increase in shipping would be noticed more readily and cause the Transportation stocks to begin rising based on rising shipping activity. The Dow Industrials might even fall to a new low in such a case, but NOT be followed by the Dow Transports.

In summary, a new high or low in the Industrial average, not 'confirmed' by the Transportation average or vice versa, should be looked at closely. In the case of a new high in the Industrials not confirmed by the Transportation stocks, it may indicate slowing earnings and hence stock prices, will show up later on in the INDU average.

In 1999 both the Dow 30 AND the Transports went to new closing highs as you can see on my first chart above and which is shown again below. Then in early-2000 TRAN went to a new closing low, which was not confirmed by INDU at least in that same year. However, in 2001 INDU 'confirmed' the action in the Transports by also falling to a new closing low; both lows are noted by blue up arrows. In a real sense the action in TRAN was forecasting trouble ahead in the overall U.S. market. It's just that that view wasn't confirmed by the other average until many months later.

In 2001, lower closing reaction lows were made in both averages and this action was 'confirming' a bear market still.

The 'mother' of all Dow theory divergences, at least in recent years, came in 2003 when the Dow Transports made a double bottom closing weekly low and therefore did NOT 'confirm' the lower lows in the Industrial average that had occurred in 2002. After the double bottom TRAN low, INDU made a higher reaction low on the pullback into early-2003. This was THE time to put everything that you could have had committed to stocks into the market. The big money is made when new trends are realized early!

As to new closing highs, one was made in early-2004 in the Transports, but wasn't confirmed, at least by any significant degree, in the Dow Industrials as noted at the dark-red down arrow. By the 3rd Quarter of 2004, TRAN started a sharp advance, which was only barely confirmed by INDU in late-2004/early-2005, but it WAS confirmed. In a real way here the action in TRAN was forecasting the very strong bull market that followed beginning in late-2005. This was a lag of nearly a year before the same kind of powerful rally was seen in the rest of the market sectors (not just in key transportation stocks), but as said before, long-term trends can unfold slowly.

All in all this story of Charles Dow and notes relating to his market theory as seen over the past several years might be more riveting than the current stated non-state of play regarding Dow's namesake newspaper and whether it ends up in the hands of new owners (Bancroft family ownership dates to 1902!), but stay tuned...there are often surprises in the takeover game. Hey, you got to convince the younger family members too!!


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