Using Dow Theory to evaluate market direction
According to Charles Dow, the father of technical analysis, the market has three types of moves.
- Short Term move: is the least important move lasting from days to weeks.
- Intermediate move: this could be classed as a secondary reaction or pull back in a Bull Market, lasting from weeks to months.
- Primary Move: This is the most important move providing most of the gains, lasting from months to years.
The market is always at an interesting point. Up or down is always the question on everyone’s lips. To try to make sense of it, we will use elements of the famous “Dow theory” to help us assess where we are.
Dow suggests that when the markets are moving together in the same direction, this is a confirmation that all is well. However, if the DJ-20 transport index, for example, starts to move downwards away from the other indices, then this is a signal that all is not well in the markets.
Analyzing the S&P-500, Dow Jones Industrials and the Dow Jones Transport together will enable us to get a good view of the market to assess if they confirm each other. This analysis should be part of your weekly regime. Being in cash when the market decides to turn down is ideal, and buying stock on the upturn is optimal.
The chart below shows an example.
Resistance at 1100 points still with the possibility of a rising head and shoulders top.
Possible retracement to the neckline of the head and shoulders and a downwards breakthrough could be very bearish, especially on rising volume.
Here we see the three-month channel the Industrials are currently in
A break of the channel either up or down will give a strong sign
Price looks to be turning down at resistance.
DJ20 Dow Transports. Here it gets really interesting!
Technical analysts call this a Megaphone Top or Broadening Triangle.
This is quite a rare pattern and significant.
However, this is known as a failing megaphone top as the top resistance line is not rising.
This suggests significant indecision in the market, and penetration of either of these lines will signal the direction of the market at least for the short to medium term.
So what do we know?
We know all three indexes are at major resistance points—all three looks to be making a reversal. A strong break through the upper resistance lines will be significant, and the market could take off from here.
Using the Dow Rule:” The Indexes must confirm,” we see that the DJ-20 is not confirming the new high made by the DJ-30. It may do this in the future, but in this example, it is not the case.
Also, on all indexes, we have diminishing volume, oversold conditions, and a perception that such a sustained eight-month move without significant pullback is dangerous.
One can be ready to pounce and move all one’s funds back into the market, but only when the market gives a clear signal.
Probability says the short term (days to weeks) will be down. If the resistance lines are broken on the upside, then this could be another story. But stock traders work on probabilities not certainties as few things outside death, taxes, and getting locked out of your own house are ever certain.