- The 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 average, as traders look for a move in one to be confirmed by a move in the other.
- On Wednesday, the Dow Jones transportation average closed at a record high. 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 expanded on, giving rise to “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 is that both averages, over time, should move in tandem, given that the transportation average represents companies responsible for the movement of goods across the country. For that reason, it should serve as a leading indicator.
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Put differently, both depend 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 look for confirmations and divergences between the two indexes.
A confirmation is when the transportation and industrial averages reach new highs (or lows), signaling 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 record high. The index has been driven by a surge in the parcel-delivery companies FedEx and UPS, which have surged 205% and 114% from lows in mid-March.
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Adding to the gains have been railroad companies, which have seen a steady uptick in demand during the COVID-19 pandemic.
Katie Farmer, BNSF Railway’s incoming CEO, 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-to-196,000 range.”
Meanwhile, the Dow Jones industrial average has not recently achieved a record high. Technical analysts will be looking for that average to follow the trend of the transportation average.
The index closed at a recent high of 29,100 on September 2, representing immediate upside potential of 3% (800 points) from Wednesday’s close.
If the industrial average confirms the transportation average’s record high, traders will look for the primary uptrend to continue in the stock market as the economy recovers from the COVID-19 pandemic.
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