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Dow Theory dates back more than a century.  It is a study of the stock market through the performance of two indexes—the Dow Jones Industrial Average ($INDU) and the Dow Jones Transportation Average ($TRAN).  Put simply, if the two averages are moving to new highs together, the markets advance is healthy.  On the other hand, if one average moves to new highs and the other does not, it is a sign that the bull market is reaching an end.  In short, the two indexes must confirm each other’s moves.  During the stock market’s latest advance, both the transports and the industrials have been moving higher together.  So does this mean that Dow Theorists are currently bullish on the market?

In order to understand Dow Theory, one must first understand the origins of the Dow Jones market averages.  Charles Dow originated both the Dow Jones Industrial Average and the Dow Jones Transportation Average in the late 19^th century.  The industrial average was created in 1896 and consisted of twelve of the leading companies of the late 1800s.  Since that time, the list has expanded to include thirty stocks, but General Electric (GE) is the only original member that still remains part of the industrial average today.  

In 1884, Mr. Dow created the first official average.  The Dow Jones Railroad Average was computed daily and its value was published in a financial publication known as the Customer’s Afternoon Letter (a predecessor to today’s The Wall Street Journal).  At that time, the railroad average consisted of nine railroad companies.  Through the years, airline, air transport, and trucking companies have been added to the index.  It now includes twenty companies and is known as the Dow Jones Transportation Average.  

Dow Theory is a study of the performance of the industrial average and the transport average together.  Mr. Dow did not invent the theory itself.  However, many of his thoughts and ideas underlie the theory.  Basically, Dow Theory is a tool for gauging whether the stock market is in a bear market (prolonged period of falling prices) or bull market (sustained period of rising prices) by considering whether the industrial average and transportation average are moving together.  According to Dow Theorists, in order for a market trend to have staying power, the two averages must confirm each other’s rise and falls.  During a bull market, both the Dow Jones Industrial Average and the Dow Jones Transportation Average must move to new highs together in order for the advance to have staying power.  However, if the industrial average sets a new high, but the transportation average moves lower, it gives a bearish signal. 

According to Dow Jones & Co.,

If the industrials reach a new high, the transports would need to reach a new high to ‘confirm’ the broad trend. The trend reverses when both averages experience sharp downturns at around the same time. If they diverge for example, if the industrial average keeps climbing while the transports decline watch out! . . . The underlying fundamentals of the theory hold that the industrials make and the transports take. If the transports aren't taking what the industrials are making, it portends economic weakness and market problems, Dow Theorists maintain.

Although Dow Theory was the product of the work of Charles Dow more than a century ago, it is still followed by a handful of traders today.  The idea is to look for significant moves in the stock market, which are separated into the primary trend, secondary trend, and daily price movements.  The daily price movements are generally ignored because it is difficult to draw significant conclusions from the stock market’s short-term fluctuations.  The secondary trend is a period of a few weeks or months in which the market moves higher or lower.  Recently, the secondary trend has been bullish.  As we can see from the chart below, the industrial average and the transports started moving higher in March of this year and both have been rising to new highs together ever since. 



While the secondary trend in the stock market appears healthy according to Dow Theory, last time the market witnessed a change in the primary trend was in May 1999. A bull market that began in 1982 ended at that time when both the industrial average and the transportation average hit peaks. From that point forward, the Dow Jones Industrial Average hit another new high several months later in January 2000, but during that rise, the transports began a move lower.  The highs set in January 2000 are highlighted on the chart.  

Since the Dow hit a high in January 2000, both averages have been in a long-term decline and stuck in a three-year bear market.  The next signal Dow Theorists will be looking for will be for both averages to break their downward sloping trend (highlighted on the chart).  However, the most convincing and bullish signal will occur when both the Dow Jones Industrial Average and the Dow Jones Transportation Average rise above the January 2000 highs and begin to set new all-time highs together.  That, it appears, is quite a long way off.

Frederic Ruffy
Senior Writer & Index Strategist
Optionetics.com ~ Your Options Education Site
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