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100-Year-Old Dow Theory is Sending a Warning

“There is always a disposition in people’s minds to think the existing conditions will be permanent. When the market is down and dull, it is hard to make people believe that this is the prelude to a period of activity and advance. When the prices are up and the country is prosperous, it is always said that while preceding booms have not lasted, there are circumstances connected with this one, which make it unlike its predecessors and give assurance of permanency. The fact pertaining to all conditions is that they will change.

– Charles Dow, 1900


The Ivory Hill RiskSIGNAL™ has remained green since December 5th. Our short-term and mid-term volatility signals have been red since last month, and they are working, as evidenced by the recent sell-off in stocks. The long-term signal is showing early signs of breaking down but we will need to see much more downside for it to trigger a red signal.


 

I like to monitor technical indicators to support my fundamental analysis. For the stock markets, that means keeping a finger on the pulse of Dow Theory.


As a quick refresher, Dow Theory is one of the oldest and most time-tested technical trading/investing strategies in the history of markets. Charles Dow first published his technical findings in the early 1900s (he was the first editor of the WSJ), including the following six tenets of Dow Theory:


  1. The market discounts all news

  2. The market has three trends

  3. Trends have three phases

  4. Indices confirm each other

  5. Trends are confirmed by volume

  6. Trends continue until definitive signals indicate otherwise


We don’t need to dig into all of these tenets individually (Investopedia's definition of Dow Theory). Still, the main idea behind Dow Theory is that markets discount all fundamental information and can offer signals about market trends in themselves. Additionally, the Dow Jones Industrial Average and Dow Jones Transportation Average must confirm the trend in each other as a divergence suggests a nontypical economic expansion or contraction that’s not sustainable.


One of the key principles of Dow Theory is that "All News Is Discounted in the Stock Market." This principle is particularly fascinating because it was formulated by Charles Dow in the late 19th century, long before the advent of the internet, television, and radio. I find this a little comical because if there had ever been a period when the news might not have been fully incorporated into market prices, it would have been during Dow's era in the late 1800s.


Nevertheless, the idea that news is reflected in market prices forms a core tenet of Dow Theory. Assuming that prices incorporate all available information, the Dow Jones Transportation Average is warning about the sustainability of the recent surge to record highs by the broader S&P 500 in 2024.


Dow Transports's current warning is rooted in another of Dow Theory’s six tenets: “Indices confirm each other.” In simple terms, Dow argued that the economy could primarily be divided into two categories: industrials, which are companies that produce goods, and Transports, which are companies that move goods.


Dow figured out that during periods of robust economic growth, the stock prices of both industrial and transport companies would rise together, "confirming" each other's bullish trends and simultaneously indicating a strong underlying economic health. Conversely, when both sectors saw declining prices, it typically suggested a significant drop in demand, consistent with an economic slowdown or recession.


Under Dow Theory, if either the Industrial or Transportation stock average exhibits a series of higher highs and higher lows, and the other average confirms this pattern, it signals a bullish outlook for the broader stock market, indicating a strong upward trend. On the other hand, if one of these averages records lower lows and lower highs, and the same trend is observed in the other average, Dow Theory interprets this as a bearish signal, suggesting that the market trend has decisively shifted downward.


Considering this, it is uncommon for both averages to reverse direction simultaneously. Therefore, if one average starts to diverge from the primary trend, it is a warning sign for both the stock market and the economy. Assuming the initial trend was bullish, followers of Dow Theory would watch for one of two scenarios:


  1. The diverging average that initially rolled over to stabilize and then resumed its upward rally or

  2. The average that was still trending upward to begin rolling over.

This observation helps investors anticipate potential shifts in market dynamics.

In the first scenario, if the average that initially diverged recovers and resumes its upward trajectory, the bullish signal remains intact according to Dow Theory. This scenario upholds the theory's requirement that both averages must confirm each other’s movements, and as such, the continuation of the bull market is supported.


In the second scenario, if the upward-trending average begins to decline, thereby confirming the initial downward movement of the first average, it would indicate a bearish reversal. According to Dow Theory, this confirms a shift in the primary trend of the broader market to the downside, signaling a potential onset of a bearish market phase.


Dow Theory Update: Bearish Divergence Identified in Transportation Sector.

In 2024, the Dow Jones Industrial Average has achieved new record highs, following closely behind the S&P 500 and Nasdaq Composite Index, though it has advanced at a slower pace than the S&P 500 and Nasdaq. However, the Dow Jones Transportation Average presents a contrasting picture. It has not reached new record levels and still sits considerably below its peak from late July of the previous year. Notably, the Transportation index marked a "lower high" after recording a "lower low" in October, which breached the previous lows set in late April 2023. These key technical movements are distinctly highlighted on the charts: the Dow Industrials show significantly higher highs and higher lows marked by green circles, and the Dow Transports display significantly lower lows and lower highs marked by red circles.





The recent developments indicate a heightened risk of reversing the bullish Dow Theory signal that was confirmed in early July 2023. In hindsight, the validity of this bullish call was already under scrutiny in October of the same year, as the stock market declined nearly 10% from the time of the signal until the end of October— suboptimal timing. Despite this, a broader view of the market's performance from the week of July 10, when the bullish signal was made, to the October lows shows an 8% drawdown in the S&P 500. However, from July 10 through the end of the first quarter of this year, the market rebounded with an overall gain of more than 16%. This translates into a risk-reward ratio of 1:2, which, although positive, is not ideal.



The recent emergence of lower lows and lower highs in the Dow Jones Transportation Average, beginning late last year and extending into 2024, indicates a divergence from the primary bull trend recognized by a bullish Dow Theory signal since early July. Going forward, Dow Theory enthusiasts will monitor two potential scenarios: either the Transportation index must set new record highs, negating the recent bearish pattern and maintaining the bullish Dow Theory outlook, or the Dow Industrials must start to show a pattern of lower lows and lower highs. If this second scenario plays out, it would confirm the bearish trends observed in the Transportation sector, leading to a reversal of the Dow Theory from bullish to bearish.


It is important to note that the last transition from a bullish to bearish Dow Theory signal occurred in early May 2022. This strategic pivot helped followers of the Dow Theory avoid more than 15% of the downturn through the October lows of that chaotic year, demonstrating the critical role of this theory in informed investment decision-making.


And remember - The one fact pertaining to all conditions is that they will change.


Feel free to use me as a sounding board.


Best regards,


-Kurt


Kurt S. Altrichter, CRPS®

Fiduciary Advisor | President



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