Dow Theory is one of the oldest trading strategies.
Having been created in the early 1900s from the writings of the first editor of the Wall Street Journal, Charles H. Dow, the Dow Theory utilizes sector rotation as an early warning of market trend changes.
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The phrase, “What the industrials make, the transports take”, captures the essence of the strategy, suggesting that the industrials and the transports should both confirm one another in price trend.
Transports vs. Industrials
The Dow Jones Transportation Average (DJI:^DJT) is actually older than the more widely quoted Dow Jones Industrial Average, but today’s Transports Index looks much different than its original version.
When the Transportation Average was created in 1884 by Charles Dow, there were only 11 constituents, nine of them railroads.
Today’s version of the Index (NYSEARCA:IYT) holds 20 companies with only four of them railroads.
Regardless of the arguments that today’s transportation index is less important than the one at the turn of the 19th century due to today’s different kind of economy, the relationship between the transports and the industrials (NYSEARCA:DIA) still matters as the Dow Theory strategy remains reliant on both of these important indices confirming one another.
Dow Theory in Action
There are six primary tenets followed in Dow Theory, but for purposes of this article I am going to focus on the one most pressing today.
Dow Theory requires these two indices to confirm one another. When the Industrials (NYSEARCA:VIS) make a new price high, the Transports should too, otherwise it is a sign of potential market weakness and vice versa.
Right now the markets are at a very interesting juncture because the Dow Industrials (NYSEARCA:XLI) and Transports have both made new intraday price highs, but only the Transports have confirmed new closing price highs since prior highs were made in July.
Check out the first chart below which shows the intraday price highs recently made by both the Transports and the Industrials. On an intraday basis both indices have confirmed one another with new all time highs.
For more short term traders of traditional Dow Theory, when the Transports joined the Industrials in new highs this week, it would have confirmed a Dow Theory buy signal.
However, for more traditional traders, utilizing market closes and longer term signals, only the Transportation Index has made a new closing high, thus not providing a buy signal, not yet anyway.
The chart below shows that on a closing basis the Dow Jones Industrial Average (DJI:^DJI) has lagged the Transports, not yet making a new closing price high above its July levels. The Transportation Average, however, did so earlier this week.
If this continues, then a Dow Theory Non-Confirmation will have occurred. A non-confirmation is when one of the indices makes a new high or low but is not confirmed by the other index. Such an event is not a signal to short or sell either of the indices, but it is a red flag to watch for a potential change in trend.
However, if the Dow can close above 17,138 (it’s flirting with it as I type on 9/3), it would confirm the Dow Theory buy signal.
Right now the Dow Theory strategy is at an interesting juncture as intraday has already signaled to buy the market, but on a closing basis, there has been no such signal, yet.
The non-confirmation sets up the potential for the next top to be forming in the markets, if the Dow can’t join its cousin in new highs.
My recent research piece highlighting some statistics surrounding September suggests even if a buy signal is confirmed, investors should remain skeptical. Not only is September the weakest month, with the markets typically declining in value, but after such a strong August (which we had), that risk of loss becomes significantly greater.
The latest issue of the ETF Profit Strategy Newsletter uses technical, fundamental, and sentiment data to keep investors on the right side of the markets. Right now Dow Theory hasn’t yet confirmed another break out to new price highs but is flirting with it. Until that occurs, it leaves the market susceptible to the September pullback.