Dow Theory goes all the way back to 1896 when Dow Jones founders Charles Dow, Edward Jones and Charles Bergstressor developed the Dow Jones Industrial Average (DJIA) along with the Dow Jones Transportation Average (DTX). The theory is based on the thesis that if business conditions were healthy and the economy is doing well, then transportation stocks should be profiting from the freight required to support the increase in economic activity. This means that we should see the transportation index moving higher along with the DJIA during economic good times. However, if the transportation starts to show weakness while the Dow moves higher then it can be seen as a sign of a potential downwards correction in the Dow. This divergence can help give us insight into future market activity.
Current level 1 students studied Dow Theory a couple weeks back as part of our intermarket analysis module but what got me thinking about Dow Theory this week was seeing charts popping up in our lounge showing a big weekly M in the transportation index. Sure enough an M top confirmed last week and price has continued to come off starting this week. While we are seeing this M in the DTX, we can’t say that a divergence has been confirmed at the time of writing this post but the DJI has a potential M that could confirm this week. If that turns out to be the case then the indexes will still be in convergence and it will be too soon to make any conclusions from this analysis. If the Dow turns around and heads higher this week it could end up putting in a W and the Dow Theory divergence signal will fire on that divergence. “Only time will ta-hell” they say and we will just need to wait and see what happens this week.
Of course this signal is just one piece of analysis that is not set in stone or a sure thing. As investors I think we can use it to help us get a context for broader market conditions but it’s not a reason to take a trade in and of itself. If anything I think we shouldn’t be surprised to see this signal potentially coming in way up here at the top of the range. Seeing this well defined M in the transports is a sign of future bearishness and looking at the Dow itself I see a confirmed bearish MACD div and a polite little M in price at the top of the range. Because the two indexes are not in divergence it’s not exactly a Dow Theory sell signal but instead maybe a sign of a healthy bull market that is in need of a correction to cool off a bit. The 38.2 Fibonacci retracement level on the DOW is -17% down from where we are now and a pullback to that level could occur inside of a bigger picture healthy bull market. Also the S&P poked to new all time highs on Friday and is looking like it could make another new high today. It’s still pointing up and aside from an overbought condition in the Willy Indicator and some potential divergences in momentum I’m having a hard time finding anything particularly bearish about it. With ongoing money printing and stimulus it’s hard to imagine the top will come in right here and now. On top of that, if we do see a sizable correction it’s likely the Fed will step in and support the market. Also, as Brian pointed out in today’s Daily Brief, we probably shouldn’t be looking for a top until after the pandemic has fully played out. The powers that be aren’t going to let the market break before that.
In conclusion it’s a little too early to confirm a Dow Theory Sell Signal but it is something that I will be watching closely to see if confirmation comes this week. Check out our Daily Brief Recap from today to hear Brian’s thoughts on Dow Theory towards the end of the broadcast. He also covers some stock ideas and looks at the bottoming action we are seeing in crypto today.
As always, happy trading!