Dow theory, dating from Charles Dow's market observations made in the late-1800's are still relevant in terms of forecasting the major market trend. Not many financial truths are the same from even 30 years ago!

I received a note from a fellow trader and OIN Subscriber who wanted to know why I've claimed, even through the May to August downturns, that the primary or major trend in the Market remained UP or bullish. Maybe now that the market has finally cleared its June and August highs it makes more sense but it DIDN'T to this trader when the Dow closed at 9686 in early-July.

My trader friend thought that the major trend should have reversed to bearish with the June (2010) monthly Dow 30 (INDU) Close at 9774, which was below the prior lowest monthly close in January at 10067. This is the way that we might figure the major trend in terms of conventional chart analysis; i.e., the primary trend in terms of INDU would now be considered to be down/bearish until there was a monthly close that exceeded the April (2010) Closing high of 11008.

However, there is another means of calculating the primary or major trend in the stock market, which is to utilize the tenets of Dow Theory. This may not mean much to you as an options trader, but many of us have also have wanted to decide whether to stay fully invested in equities versus other investments. Well, probably not real estate and maybe not low-yielding T-bonds, but my gold bug friends never tire of telling me how much gold is up since they bought into it. There are always alternatives. I hold a rental property in Spain that pays in Euros for example, so there's a currency play there.

Here's the chart I look at weekly that has to do with the trend in terms of Dow theory, which compares weekly closes in the Dow Industrials (INDU) versus the Dow Transportation (TRAN) average. If market participants know anything about Dow theory, what they 'know' is something about a new low in INDU must be 'confirmed' by a similar new low in the Dow Transports. Charles Dow would have only used a monthly calculation, whereas today it's also common to look at weekly chart comparisons, which is what I'm showing in my first chart. However, there's a LOT more than this to Dow Theory.

It's necessary to understand that Charles Dow considered his ideas on the market (he didn’t call it his market 'theory') to provide the big picture for investment purposes. He used closing prices only. Moreover, he would usually consider monthly closes in the market, rather than even on a weekly basis. I'll get to Charles Dow and his major contributions to understanding the phases of a market trend and to present era technical analysis in a companion article later this week.

Dow Theory is not a system of market timing as we think of it exactly, only a forecaster of the major or 'primary' trend; i.e., the trend year over year, not for mere months, as seen in the bearish dips prior to September, with all the accompanying bearish sentiment. The so-called Dow Theory is first and foremost a good forecaster of recessions. Now that I’ve suggested (above) where we stand currently in terms of a Dow Theory 'signal'; i.e., still on a 'buy' or 'stay invested' track, I'll back up and talk about Charles Dow, who is the father or really 'grandfather' of technical analysis.

Back in the 1880’s and 1890's, Charles H. 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 the 'Dow 30' as these stocks have become more technological, manufacturing and service oriented and less industrial. This, unlike the case of the heavy industry stocks like U.S. Steel that were part of the early Dow Industrials.

Today's common terms are 'the Dow' or 'Dow Jones 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 they’re 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 these larger companies with far more shares outstanding like the S&P 500(SPX). Companies with higher stock prices in the Dow, such as IBM, will have a proportionally bigger effect on the Dow Average.

Only the Dow Industrials and Dow Transportation (then a group of railroad stocks) averages are used in what became known as 'Dow theory'. Charles Dow never called the market principles he wrote about a theory, only observations on how the economy and the market functioned. Dow’s principles were later discussed in a book by the Wall Street Journal Editor that succeeded Charles Dow, William Hamilton, and was called The Wall Street Barometer. Robert Rhea is credited with distilling the ideas of Dow further and wrote a book in the early 1930's called Dow Theory. That book is the popular origin of this term.

One of Charles 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, the flip side of it, is the concept of divergence. Dow spoke mostly about 'confirmation' or divergences between the two averages; or, between prices and volume trends. 'Divergences' between price action and (technical) indicators is a related concept that came in the last century as put forth by various technical analysts.

What Dow said was that if the Industrial stock average moved to a new closing high or low, without the Transportation average following suit or 'confirming' a similar new peak or new bottom, no change in the primary trend was suggested or 'signaled'. I'm talking about the situation where there is a potential reversal in the primary trend. To suggest such a change, such a trend reversal, the averages must be sync.

The reasons for this are simple, but accounted for a very astute observation on Dow's part especially for the late-1800's! 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. Where such a slowdown would show up however, is in transportation orders and activity. Slowing orders in the transportation sector, as fewer goods were shipped, would result in a fall off of company 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 stock prices for manufacturing stocks. However, an increase in shipping might be noticed more readily and cause those stocks to begin rising. The Dow Industrials might fall to a new low, but not be followed by the Dow Transportation stocks.

Therefore, a new high or low in the Industrial average, not matched or 'confirmed' by the Transportation average is suspect. In the case of a new high not confirmed by the Transportation stocks it may indicate that the same slowing of earnings and hence stock prices, will show up later on in the Dow Industrials.

As an historical example, back in 1994 there was another important case of a new low in the Dow Transports not being followed by a new low in the Industrials. Here I use a weekly chart, but the result would have been the same on a monthly chart basis:

In the chart above, we can assume that manufacturing was holding relatively steady (perhaps there was not a big 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).

A different sort of 'non-confirmation' is when a new low in the Industrial average is not confirmed by a similar new low in the Transportation stocks. It may be that shipments of goods has started to rebound and has shown up in a slowing of the decline of the transportation stocks or in an actual upturn in their prices, whereas industrial companies are just shipping already produced and built up inventories. A rebound in their earnings lies ahead still, after they start up their manufacturing lines again in earnest.

In my next chart, depicting the 1998 to 2000 period, it is striking how failure to confirm new relative highs in the Dow Industrials in both 1998 and again in 1999, by a similar move in the Dow Transportation average, preceded major downside reversals in the Dow Industrials within a few weeks to months. The 1999 example is the most striking:

In the period shown in the above chart – you can observe that as the Industrial average was going to greater and greater highs, the transportation average was moving to ever-greater lows. Eventually, there was a sharp decline in the Industrials into late-1999 into early-2000, followed by a lengthily sideways trend with no further new highs. This in turn was followed by the Dow falling eventually to its 2002 weekly Closing low of 7528. A result of 9/11/2001 as well but the major market downtrend began with the price action seen above in 1999-2000.

It will be interesting to see, in terms of Dow Theory, how many more months and years the primary uptrend can continue dating from the 2009 bottom. For a long-term bull market, it will be important for eventual new Closing weekly highs to be made in BOTH Averages; i.e., above 11204 in INDU and 4751 in TRAN.