- Dow Theory – a financial theory named after the father of technical analysis, Charles Dow – just flashed a bullish signal suggesting more upside ahead for the broader stock market.
- The theory is based on the relative price action of the Dow Jones industrial average and the Dow Jones Transportation Index, as traders look for a move in one to be confirmed by a move in the other.
- On Wednesday, the Dow Jones Transportation Index closed at record all-time highs, which, according to the theory, would suggest that the Dow Jones industrial average will soon follow.
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Following the death of Charles Dow in 1902, hundreds of his editorials published in the Wall Street Journal (which he founded) were compiled and further expanded upon in a series of works. It ultimately garnered the name “Dow Theory.”
Coined by S.A. Nelson, and refined by William Hamilton and Robert Rhea, Dow Theory is the study of the intermarket relationship between the Dow Jones industrial average and the Dow Jones Rail Average (now called the Transportation Average).
The general idea behind the theory is that both averages, over time, should move in tandem given that the Transportation Average is responsible for the movement of goods across the country. For that reason, it should serve as a leading indicator.
Put differently, both are dependent on each other. If the economy is thriving, transportation companies should also be thriving as they are tasked with literally moving the economy.
Technical analysts look to Dow Theory to confirm broad movements in the stock market. Specifically, traders are looking for potential confirmations and divergences between the two indexes.
A confirmation is when both the Transports and industrial averages break out to new highs (or lows), which signals that the trend in the broader market is up (or down). A divergence is when one of the two averages isn’t moving in tandem with the other.
On Wednesday, the Dow Jones Transportation Average closed at a new all time high. The index has been driven by a surge in parcel delivery companies FedEx and UPS, which have surged 205% and 114% from their COVID-19 lows in mid March, respectively.
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Adding onto the gains are railroad companies, which have seen a steady uptick in demand since the onset of the COVID pandemic.
BNSF Railway Incoming CEO Katie Farmer told CNBC last month, “In the depth of the pandemic, our rail loadings were actually down to about 150,000 units a week. Now, we have seen that continue to come back. And we anticipate this week we’ll handle somewhere in the neighborhood of mid 195,000-196,000 range.”
While the Dow Jones Transportation Average has closed at record highs, the Dow Jones industrial average has yet to achieve the same milestone.
Technical analysts will be looking for the Industrial Average to follow the trend of the transports and also break out to new highs. The index closed at record highs of 29,100 on September 2, representing immediate upside potential of 3% (800 points) from Wednesday’s close.
If the Dow Jones industrial average confirms the Transports new record high, traders will look for the primary up-trend to continue in the stock market as the economy continues to recover from the COVID-19 pandemic.