• Trading 101: Dow Theory

    by  • March 5, 2013 8:15 am • Trading 101 with Peter Bryans • 0 Comments

    One of the main principles of Technical Analysis (TA) is that prices trend. Way back in the 19th century, Charles Dow made this observation of the markets and this concept was then named after him. Long story short, this theory carries several concepts that are still practiced today.

    One of the premises of Dow Theory is based upon the idea that as the Dow trends higher the transportation index needs to confirm this bullish action. The fundamentals are simple—as the thirty mega-cap firms that make up the Dow show increased strength, the transportation index reflects an increase in business activity. The movement of goods is a promising sign for these companies in the Dow, and as the Dow Jones makes a series of “higher highs” the transportation index must also follow suit.

    With the help of Senior Quantitative Analyst Rocky White, I was able to show the transportation index plotted alongside the Dow. The first featured chart is of the bull market that began in 2003 until the market peak in 2007. Notice how the transports and the Dow moved in tandem until the market hit its all-time highs in October, 2007. The Dow index is scaled on the left, while the Transports IDX is scaled on the right.

    Next is a chart featuring the current cyclical bull market that began in March, 2009. Again, note the importance of how the transports confirmed the mega-cap index. However, there is also an important time period in this chart—so look closely at this past year’s price action. From roughly May 2012 until December, the Transports IDX essentially moved sideways. This was a cautious sign for Dow theorists, and many were not convinced that the next leg higher in this bull market was going to be sustained until there was further confirmation.

    The final chart below is of the Dow plotted alongside the transports from the beginning of this year. After the sideways action in the latter half of 2012, the transports and Dow appear to be moving much more in sync  This is certainly an encouraging sign for the current rally, and is an area of interest that should be closely examined.

    Lastly, I’d like to highlight some of the individual names that make up this group of transports, and leave you with some individual tickers to keep an eye on.

    FedEx (FDX) looks good after making recent all-time highs. Look for another breakout over $106.

    (courtesy of StockCharts.com)

    Canadian Pacific (CP). Making new all-time highs.

    (courtesy of StockCharts.com)

     Union Pacific (UNP). Another strong name making all-time highs.

    (courtesy of StockCharts.com)

    One final point–this overview of the Dow Theory is clearly a much longer-term picture of the market. We have had some wild price action as of late, and some obvious indecision between the bears and the bulls. Keep the transports in the back of your mind, and be on the lookout for this to continue as one of the leading sectors.

    About

    Peter Bryans joined the Schaeffer's Investment Research trading team as a Trader in April, 2012. A graduate of the Fisher College of Business at The Ohio State University -- where he concentrated in Finance -- Peter previously held internships with an insurance broker and a wealth-management firm. In his current role, Peter trades a variety of our real-time option services and also hosts our "Options Apprentice" weekly webinar presentations.

    http://www.schaeffersresearch.com

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