Article contributed by Jeremy Whaley

In Part 4 of our series on Dow Theory, we focused on the third tenet: major trends have 3 phases. In this article we are going to focus on the fourth tenet, which is a leading indicator of future direction: the averages must confirm each other.

As a quick refresher, the 6 tenets of Dow Theory are:

1. The price discounts everything.
2. The market has 3 trends.
3. Major trends have 3 phases.
4. The averages must confirm each other.
5. Volume must confirm the trend.
6. A trend is assumed to be in effect until it gives definite signals that it has reversed.

The Averages Must Confirm Each Other

As I mentioned in Part 1 of this series, one of Dow’s best-known contributions to the world of stock market analysis is the stock indexes that bear his name. So popular and well known is the Dow Jones Industrial Average that many mistakenly refer to it as “the market”! In fact the industrial index is really nothing more than an index of 30 stocks that track major industry in America.

Back in 1896 when Charles Dow and Edward Jones first created the index, they started with 12 companies. Just a few short months later they created another index known as the Dow Jones Transportation Index. The Dow Transports, as it is often called, was created to track the transportation sector of the market. The original index included the stocks of 9 railroads and 2 non-railroad companies.

The reasoning behind the fourth tenet of Dow Theory goes like this: If the industries in America are doing well and creating goods, the industrial index will move higher. If the goods being created are being shipped to customers, then the transportation index will go higher as well. If, however, the goods are being created but not being shipped, then the industrial index will ultimately fall because of a lack of demand for goods.

This idea leads to the concept of Index Divergence, which says that when the indexes are moving in the same direction, they confirm each other and thus confirm the state of the economy. If, however, the indexes begin to move in different directions (diverge), then the indexes are alerting us to a larger fundamental problem.

Let’s try to put some hard numbers with this and drive the point home a little more. Let’s say the industrial index has moved from 350 up to 400, but the transportation index has moved from 225 down to 200—the two indexes are moving in opposite directions. This is called divergence. What it means (in theory) is that while a greater number of goods are being produced, those goods are not actually shipping. The lower transport levels show a slow down in shipments, which inevitably will lead to a slow down in production and consequently a lower tracking in the index.

This concept of following the indexes and making sure the indexes confirm each other was a very early form of a technical indicator. Today this particular tenant of Dow Theory is less applicable than some of the other tenets, as we have several other indicators that may help us better understand what the market is doing. But at the time of Dow’s writings, this was revolutionary. It’s one of the many things Dow did to earn himself the title “The Father of Technical Analysis.”

If you would like to learn how to apply Dow Theory to your own trading, please visit our website and sign up for a free class. In Part 6 of this series we will look at the role volume plays in confirming a trend and how you can use it to better time your trades and understand the next move of a stock.

Jeremy Whaley is co-founder of Trade Smart University, an education company dedicated to helping everyday people learn to trade the stock market for consistent profits. If you would like to learn how to trade your own money for steady profits, visit www.TradeSmartU.com and experience affordable, accessible stock market education.


Bibliography:

Kirkpatrick, Charles D. and Julie R. Dahlquist. Technical Analysis: The Complete Resource for Financial Market Technicians. Upper Saddle River, New Jersey: FT Press, 2007.

Murphy, John J. Technical Analysis of the Financial Markets. Paramus, New Jersey: New York Institute of Finance, 1999.