Dow’s Theory and the Averages

by Richard Evans

Charles H. Dow will always hold a unique position in the history of the financial markets. He was one of the preeminent journalists of his day, as co-founder of Dow Jones & Company, and the first editor of The Wall Street Journal and later Barron’s. He also devised the first index to measure the trend of the market and penned some basic principles of stock market behavior—known as the Dow Theory—that laid the foundation on which much of technical analysis is based today.

Yet the Dow Jones averages as they stand today, and the Dow Theory regarding the recurring characteristics of stock prices have been just about totally discounted by academicians, are considered irrelevant by an ever larger number of modern-day financial analysts, and even renounced by many technicians. For a variety of reasons, ranging from inherent drawbacks in the averages to distrust of the Dow Theory due to misinterpretation by some of its proponents, it is fair to say that Charles Dow’s pioneering work is increasingly being considered obsolete, relegated to the status of historical curiosity.

However, by taking some time to reflect on the Dow Theory, what the averages represent and how they should be used, investors may well find his theory of gauging the market trends still a very remarkable tool.

The Theory

In a nutshell, the Dow Theory states that there is a general trend of the market. Instead of the stock market being made up of unrelated fluctuations of individual stocks, Charles Dow thought there was an underlying market trend. The averages grew from Mr. Dow’s efforts to express the general trend of the market.

However, one key to Dow Theory interpretation, and what makes the Dow Theory practical, is the principle of confirmation and divergence. In order to have any significance, both the Dow Jones industrial and transportation averages have to confirm one another in movement. A movement in one average, unconfirmed by the other, is considered to be misleading.

The principles of confirmation and divergence are probably the least misunderstood, and certainly the most misinterpreted, facets of Charles Dow’s theory.

The Averages

To better understand the theory, it is important to understand the averages, as their interaction defines the essence of the Dow Theory. There are two criticisms of the Dow averages: First, there is the argument that the averages—with the industrials acting as the lightning rod—have lost their significance; second, there is the argument that they no longer represent the underlying confirmation rationale.

The Dow Jones 30 industrial average, still the most widely quoted measure of the market, is not considered the most “correct,” having been largely replaced by the S&P 500 and a host of other, broader indexes. [A comprehensive article on the current criticisms of the industrials was Robert Stovall’s piece, “When the Market Talks, Does the Dow Listen? Not Very Well,” in the July 1992 AAII Journal.]

However, for Dow Theory interpretation, or any trend analysis for that matter, direction is what counts, not an absolute price level. As long as the industrials represent the prices of the most actively traded issues, sensitive to major investment monies flowing in and out of the market, the Dow average will remain an important barometer of the stock market.

The significance of the Dow Jones transportation average has also come into question. A 20-stock rail average first appeared in 1896 but was revised (and retitled) in 1970, when nine other non-rail transportation issues were included. Now the transports include airlines, trucking, shipping, and even transportation leasing, in addition to the railroads.

Dow Theory critics say that the original underlying premise of Dow Theory confirmation, the industrials representing production of goods and the rails representing the shipments, was logical at the time. But now, with an increasingly service-based economy and the transportation average having a wider definition, the original presumptions are no longer valid.

Perhaps an underlying theory of the industrials representing production and the rails representing shipment of goods was Charles Dow’s original intent—most modern-day texts on Mr. Dow’s theory dutifully discuss this version. However, a strict reading of Dow’s editorials, as well as study of the development of the averages, suggests that they evolved as Dow attempted to reflect the changing shape of the stock market.

Dow’s first stock average in 1884 was only 11 stocks, 9 rails and 2 industrial issues, reflecting the preponderance of railroad issues on the stock exchange. However, industrial enterprises were growing in importance, accounting for a greater share of trading, and in 1896, Dow published the first industrial list of 12 issues. The averages grew and evolved to reflect the volume of trading on the New York Stock Exchange.

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As to the confirmation theory, Dow backed into it when he noted after studying the averages that important trends in the market tend to develop only when both averages are confirming. The industrials and rails represented two different economic sectors to be sure, but the importance of the two averages today, just as in Dow’s time, is as a measure of breadth.

Further, the implications of the interaction between the industrial and transportation averages may be even more significant today. The industrials are increasingly being driven by indexing, such as those based on the capitalization-weighted S&P 500 index; in fact, while the 30 Dow stocks only make up a small percentage of the number of stocks in the S&P 500, the 30 Dow stocks alone account for over 25% of the market value of the S&P 500 index.

The transports, on the other hand, remain highly sensitive to changes at the margin of the economy, to changing expectations of future earnings. The transports remain most keenly sensitive to the factors that drive business cycles and the general level of stock prices. The transports are an important leading market indicator.

The Recent Record

So much for theory. Last year serves as a good illustration of how the theory can be put to work; Figures 1 and 2 present the Dow Jones industrial and transportation averages for 1992.

Through most of 1991 the industrials and the transports were in gear. In 1992, however, the industrials kept moving higher, while the transports began to diverge persistently.

Through the first two months of 1992 there was clear sailing. However, while the industrials continued strong through April and May, the transports began to falter. The last confirmed new highs on both the industrials and transports were in the week ended February 21. Thereafter, while the industrials continued to move higher, the transports not only failed to confirm the new highs in the industrials, but began to diverge by moving lower.

While any divergence can be resolved to the upside—that is, the transports could get into gear by moving higher along with the industrials—I’ve increasingly come to expect the weaker average to pull down the stronger, sort of a Gresham’s Law.

In any case, while the industrials through the end of July still had bullish momentum, the transports persistently lagged. Dow Theory-wise, the market climate was weakening, with the industrials losing momentum during the summer, culminating in a minipanic on Monday, October 5, when the Dow plunged 104 points in the first two hours in frantic trading.

In explaining the panic, analysts cited an unusual confluence of economic concerns. I looked at the panic as the result of eroding market momentum, as indicated by a very badly behaving transportation average, capped off by a decline in the Dow Jones industrial average the previous Friday through support at 3225.

The Next Move

Now, the next question is: What will occur after the industrials “give in” to the transports? Up to the point of panic we could expect the industrials to cave in, which they did. But did it indicate a bear market, or just the final panic-selling climax that accompanies all secondary corrections in the market? What would be played out next? The transports would hold the key.

While the jolting decline in the industrials raised the possibility that the overall market was perhaps in a bearish trend, the transports failed to confirm. All eyes were on the breakdown in the industrials, and some interpreted Dow Theory as suggesting that a bear market was at hand.

On the contrary, the transports were in the process of indicating the end of the correction.

First, during the decline that carried the industrials to new lows, the transports refused to confirm the industrials as the transports held above their previous lows of August 26. Then, in the subsequent two weeks, the transports smartly moved to new intermediate highs by rising above the September 14 highs.

The sharp declines during the week ending October 9 were a pivotal point, to be sure, but not in ushering in a bear market, as thought by some, but instead, being a pivotal point representing the change in momentum for the transports from bearish to bullish. After many months of being a drag on the market, the transports had in fact turned bullish. Amid the growing bear market climate, the transports were giving the green light to higher prices.

1992 is about as instructive a year as Dow Theorists could ask for in highlighting the interaction between the industrial and transportation averages. AAII members are unlikely to turn into serious Dow Theorists, but the essence of the Dow Theory—confirmation and divergence—can be easily measured and may provide investors with a feel for the current market outlook.


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