I’ve seen a lot of blog posts about Dow Theory lately. Unfortunately, many of them have had a lot of misinformation about what Dow Theory is and how it should be applied to the markets. Like all types of technical analysis Dow Theory is simple in concept, but difficult in practice. In an effort to help you understand the basics I’ll do some posts about Dow Theory over the next several days that explain it and the basic rules of how it works. Today we’ll start with an overview. What is Dow Theory? In the simplest terms, Dow Theory is a study of stock market price and volume that attempts to identify the prevailing trend of the market and warn of possible changes in that trend. William Peter Hamilton formalized the theory proposed by Charles H. Dow in a book titled “The Stock Market Barometer”. He considered the theory to be a general guide to the probable outcomes in the stock market based on the combined movements of the Dow
Over the past few days the Dow Jones Transportation Average (DJTA) cleared a long term divergence it had painted with the Dow Jones Industrial Average (DJIA) going back to July of 2011. Clearing that level was one of the hurdles that Dow Theory needed to clear before creating what many call a “buy signal”. In reality, there are no actual buy signals in Dow Theory, instead Dow Theory merely confirms a long term trend or warns of an possible change of trend. It does so by following the price and volume action of DJIA and DJTA. When both averages move and break above previous secondary highs together Dow Theory states that the market is in a primary uptrend. During a primary uptrend traders should be buying dips and accumulating stocks. During the first part of 2012 the two averages painted what is call a Dow Theory Line where prices traded in a narrow range for several weeks. The top of the lines for both DJIA and DJTA created secondary highs
Keep an eye on the Dow Jones Transportation index (DJTA) and the Dow Jones Industrial index (DJIA) over the next few weeks. Both of them have now recovered to the top of the Dow Theory Line that they painted at the first of the year. The decline below the line in mid May created a secondary low point (in early June). This gives a line in the sand on the down side that both indexes must hold. Any failure would create what many technicians call a Dow Theory Sell Signal, but in true Dow Theory it will merely represent confirmation that the primary trend has changed from bullish to bearish. With both indexes close to the top of the line we’re at a point that a small move higher will serve as confirmation that the trend is still up. The transports need to clear 5370 on a closing basis, while the industrials need to close above 13610. There is a very long term non confirmation between the industrials and the
In May of this year the Dow Jones Industrial Average (DJIA) and the Dow Jones Transportation Average (DJTA) both broke down from a Dow Theory Line. When that line broke it signaled that the following low would be of at least secondary importance (or possibly signal a primary trend change). In early June both DJIA and DJTA put in secondary lows. Subsequent to that low the industrials rallied back above their last secondary high point while the transports traded in a sideways range without going on to new highs. Several times during that range DJTA got close to breaking its secondary low even though DJIA continued higher. This created a Dow Theory non confirmation that was a warning that a top could be in progress. We are now at a point where the transportation average is hovering above its last secondary low and the industrial average has broken down sharply. This makes the 4847 level on DJTA critical support. Any break of 4847 on a closing basis will put in
During the last week all of our market health and risk indicators showed weakness, however, this is a normal condition during market consolidations. As long as the indicators continue to paint chart patterns similar to price we won’t be concerned. We get nervous when our indicators turn down faster than price. When that happens it is signalling underlying weakness in the market. So far we’re of the opinion that we are currently in a normal, healthy consolidation. None of our measures of the economy, risk, quality, trend, or strength deteriorated enough to cause any changes in the portfolio. We’re still 100% long. We’re aware of the fact that consolidations can turn into larger corrections so we’ll continue to monitor our indicators closely for signs of weakness. Market Positives Our Twitter Sentiment Indicator for the S&P 500 Index (SPX) continued to show relatively good strength again last week. Two weeks of downward price movement has only brought smoothed sentiment back to the trend line we drew near the beginning of September.
The Dow Jones Transportation average (DJTA) has fallen once again to a critical support level. This is in contrast to the Dow Jones Industrial average (DJIA) hovering near its 52 week highs. This is not something we generally see in a healthy market. It is one of the few negative indicators we are watching for signs of the next major move in the market. When market rallies get tired and begin to form a top they usually do so from a position where almost every indicator we follow is positive. When an intermediate term high is forming, divergences between major market indexes, momentum indicators, and breadth indicators start to show up. The transports are getting close to painting a major divergence from the other market indexes. This often signals weakness in the general economy as fewer raw materials, supplies, and finished goods are moving. Keep an eye on the transports over the next week or two. If it breaks below the 4850 to 4900 level it will be one
One of the less frequent and lesser known patterns in Dow Theory is a “line”. Robert Rhea defines a line as, “A price movement extending two to three weeks or longer, during which period the price variation of both averages move within a range of approximately five percent. “ He goes on to state that the narrow price movement indicates either accumulation or distribution. When a line is broken to the upside the pattern is most likely accumulation. When a line is broken to the down side the pattern indicates distribution. At the first of the year the Dow Jones Transports entered a 5% trading range that lasted over 4 months. The Dow Jones Industrials traded in a narrow range for 3 months. On May 15th, 2012 the industrial average broke down from the line and was confirmed by the transport average on 5/17. William Peter Hamilton believed that the breaking of a line indicated a change in the general market direction. This change in trend could be of either