Dow Theory (Part 3)
In the final post on Dow Theory, we examine how Dow Theory applies as a broad market indicator. If you need to catch up, you can read the other two posts – An Overview of Dow Theory and Using Dow Theory to Identify Trends – by clicking the links. To some degree, this is a more classical use of Dow Theory, despite the fact that I’m addressing it last. Generally speaking, when you read articles about “Dow Theorists” prognosticating on the state of the markets, they are referring to the analysis I will describe in the rest of the post.
Charles Dow believed that, in order to confirm primary trends in the broad market, averages must conform with one another. In particular, Dow used the Dow Jones Industrial Average as a proxy for the general markets and the Dow jones Transportation Average as a conforming indicator. Why was this?
Transport stocks are typically more susceptible to economic changes than other stocks. In Dow’s time, these stocks were typically rail businesses and other freight shipping businesses which would notice shipment decreases well before the rest of the market turned down. These days, the DJTA is highly airline heavy which adds a layer of complexity to the issue as airlines are not a direct 20th century analogue to the rail and freights of years past. Yes, airlines derive much business from business travelers but they are also susceptible to changes in consumer demand. That does not mean that the transportation average is no longer applicable in Dow Theory analysis. One could say that airlines provide an even better leading indicator as their typically high debt loads create added susceptibility to interest rate changes and their fuel needs adds in a level of reaction to energy prices in addition to their susceptibility to business climate changes.
So, how do the DJTA and DJIA work together to provide a better picture of the future direction of the markets? Generally speaking, the DJTA is supposed to lead movements in the DJIA. Furthermore, trend changes in one index must be confirmed by trend changes in the other index. Spotting trends is done the same way as described in the last Dow Theory post – peak analysis with volume confirmation.
Here, I’ve graphed the DJTA above the DJIA for the last year. What we see is that the DJTA entered a downtrend just as the DJIA made its last gasp at a higher high. Later on, in the second area denoted by vertical lines, we see the DJTA bottom and make a higher high as the DJIA just reaches what seems to be a bottom of its own.
You might be tempted to conclude that the transportation average must lead the industrial average. But, this is not the case and I will reiterate that the only “rule” provided by Dow Theory is that averages must conform when signaling trend changes. An example can be found in the period between the second and third vertical lines, we see the DJTA break above its projected downtrend and make a relative high. The DJIA did not make a similar move and instead only made a lower high, the second in what would be a series of lower highs and lower lows. Thus, the only conclusive evidence we have here is that the two averages much conform with one another before a trend change is officially identified.
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