With the Dow Jones Industrial Average making new all-time-never-before-seen-highs, I thought a look at the Dow Theory as an acid test for the validity of the rally might be worthwhile.
For a brief bit of background, I’m going to paste a few lines from Wikipedia for those that aren’t familiar with Charles Dow or the Dow Theory as it’s known today:
The Dow theory on stock price movement is a form of technical analysis that includes some aspects of sector rotation. The theory was derived from 255 Wall Street Journal editorials written by Charles H. Dow (1851-1902), journalist, founder and first editor of The Wall Street Journal and co-founder of Dow Jones and Company. Following Dow’s death, William Peter Hamilton, Robert Rhea and E. George Schaefer organized and collectively represented Dow theory, based on Dow’s editorials. Dow himself never used the term Dow theory nor presented it as a trading system.
- Stock market averages must confirm each other
- Dow stressed that for a primary trend buy or sell signal to be valid, both the Industrial Average and the Rail Average must confirm each other. If one average records a new high or new low, then the other must soon follow for a Dow theory signal to be considered valid.
- Trends are confirmed by volume
- In a primary bull market, volume should be heavier on advances than during corrections. Not only should volume decline on corrections, but participation should also decrease.
The DJIA rallied almost 9% over the last three weeks, ultimately breaking above it’s previous all-time high set back in May 2015. From a Dow Theory perspective, the price action seen above is undoubtedly bullish. While price a huge determinant of primary market trends, there are other factors to consider, such as volume. As stated in the second bullet above, bull markets should see volume that is heavier on market advances than on corrections. Well, that’s exactly the opposite of what’s taking place. The DJIA broke out on absolutely paltry volume last week. In fact, volume was less than half of what it was during several weeks in early 2016 when the average was falling. This is non-confirmation red flag #1.
Now let’s look at the Dow Jones Transportation Average:
This is a three-year weekly chart just like the DJIA chart above. Here is your non-confirmation red flag #2. The DJTA isn’t even close to making a new high. In fact, it hasn’t even made an intermediate higher high as it’s still trading below it’s high from April. No doubt the chart is showing a potentialbottoming pattern, but at this point it’s still solidly in a downtrend. Volume has been decent these last few weeks, but still below the volume seen during the declines in late 2015 and early 2016.
I understand that the Dow Theory was developed over a century ago when the U.S. was a manufacturing powerhouse – back when this country actually made things. Industrials and Rails were the Googles and Facebooks of their time. So some may argue that looking at the DJIA and DJTA as indicators is an obsolete practice. Perhaps. But I would argue that 100 years of evidence argues otherwise. The bottom line is that for this bull market to succeed, volume better accompanying rallies and the DJTA better get its act together, and soon.