Thursday, February 9, 2012

Updated Dow Theory...

One of the most time consuming and difficult concepts to teach (while I taught Technical Analysis for our local school system's Adult Education "Community Educator" program for 3.5 years) was that of Dow Theory, something Charles Dow started via Wall Street Journal editorials (by the way, he also founded the WSJ), but was actually only later put together as a cohesive concept after his death by 3 men. Charles Dow never used the phrase Dow Theory nor did he present it as a cohesive system.

The gist of Dow Theory (remember this is the early half of the 20th century) was that the two major indexes at the time, the Industrials (what we now know as the Dow-30) and the Transports (known now as the Dow-20) should confirm each other, if for instance the Dow moved higher (being packed with Industrial stocks), but the transports failed to confirm (if Industrial production is truly strong, then the transports that deliver industrial goods should also be strong), you would have a suspicious market and should be wary of that market, whichever was moving without confirmation from the other.

Although the Dow-30 itself has changed dramatically over time with few true industrial stocks left in it as technology has changed the American landscape, the theory still holds up. When the market is in a bull market, rarely do the major averages diverge, they move up together. Although the beta might be different in say the Dot.com era, you would expect the NASDAQ 100 to out-perform the Dow-30, or during the housing bubble, you would expect the S&P-500 which has more exposure to financials to out-perform technology. Yet, they should move together fairly tightly.

So I quickly threw together a way to take a look at the averages real quick just to see what the confirmation between them looked like; here's what I found....

 Since the NASDAQ is the recent leader, I compared it to the Dow and the SPX using a Rate of Change indicator applied to both averages and then looked at the difference between the rate of change between the two. Although the price chart doesn't accurately reflect the volatility of the market and the moves down because the price chart is so small with 3 windows open, I did add the percent move in the areas of divergence. As you can see they diverged in July before the NASDAQ plunged over 16% in a very sharp fall, you may remember it, many people thought that the move down had no end in sight-as a side note, 3C identified the likely bottom 3 days before it actually bottomed in early August. There was another smaller move within the trading range during a divergence and as you can see now, there's a current divergence.

 A 60 min chart shows the transition a little better.

This is the daily chart of the NDX vs the SPX, we see similar divergences and at the same times as the Dow chart comparison above.


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