80-Year-Old Wisdom That Still Works

07/09/2015 6:00 am EST

Focus: STRATEGIES

Thomas Aspray

, Professional Trader & Analyst

Some market relationships never lose their predictive powers, writes technician Tom Aspray, citing timeless concepts whose impact is as evident today as it was as far back as the 1930s.

Several years ago, I rediscovered my copy of The Dow Theory, by Richard Rhea, from 1932. Now many hear the term Dow Theory and think only of the market timing aspects of the theory and not the other important concepts the book discusses.

In the original book, Robert Rhea analyzed some 252 editorials of Charles H. Dow and William Peter Hamilton so that he could present Dow Theory in a way that could be used by the individual investor. Rhea starts out by stating several concepts or hypotheses that he feels the reader must accept.

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A few of these, I feel, are essential to the field of technical analysis but are often forgotten or ignored by many traders and investors. It should be noted that even though I have followed the Dow Jones Averages closely for over 30 years, I have never relied solely on Dow Theory methods to generate stock market buy or sell signals. Let's begin with some of the important concepts.

The Averages Discount Everything: It was Rhea's view that the closing price of the Dow averages gave the truest reading of the current state of the economy, as well as the market participants' view of the future economic trends.

I have found that the more one can concentrate on just the price activity, the better they will fare. Most who try to blend their fundamental view of a market or stock with technical analysis often end up on the wrong side of the market.

A good example in 2012 was in the homebuilding stocks, as many-who saw the sad state of the real estate market in their area-missed one of the strongest sector moves.

Rhea then pointed out that the theory is not infallible, which should be no surprise for most seasoned investors. Unfortunately, many novice traders start out searching for the Holy Grail and generally do not last long.

Market trends are divided into primary movements and secondary reactions. This is one distinction that gets many into trouble and is one reason I spend quite a bit of time looking at monthly and weekly charts. Too often I have seen investors sell a stock that is just undergoing a secondary reaction in a primary bull market or buy a stock that is undergoing a secondary reaction in a primary bear market.

This can cause the most damage for short-term traders, as a market can look pretty positive from the hourly or daily charts, but quite negative based on weekly or monthly data.

NEXT: Monthly Chart of SPY Clearly Illustrates This Point

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The monthly chart of the Spyder Trust (SPY) helps to illustrate this point. In May 2008, SPY completed what I identified at the time as a bear market rally because it failed to surpass key resistance and the Advance/Decline (A/D) line suggested a major top was in place.

In early June 2008, SPY violated the May lows, and in July, it decisively violated the lows from 2008 and 2006, thereby forming a pattern of lower highs and lower lows.

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Since the lows in March 2009, the monthly chart formed higher highs in 2010, 2011, and 2012. There was also a clear pattern of higher lows. The last monthly closing low from September 2011 was at $113.15. This was an important long-term level to watch in 2012. (More about the current state of the markets later.)

The above monthly chart (see right panel) of the SPDR Gold Trust (GLD) shows a long-term pattern of higher highs and higher lows, as the 2006 high of $72.26 was easily exceeded in 2008 when the high was $100.44. Though the correction from the 2008 highs was quite sharp, it held above the lows from 2007, keeping the uptrend intact.

Of course, central to the Dow Theory is that the action of the Dow Jones Industrials must be confirmed by the action of the Dow Jones Transportation Average. This will become the focal point of the remainder of today's article.

Some have argued that the Transportation Average is less of a barometer of the economy than it was in Rhea's time, however, regular readers will know that over the past few years, careful monitoring of the Dow Transports has helped keep us well positioned on the right side of the market.

The concept of confirmation and non-confirmation plays an important role in my analysis as well, as it can provide valuable insights when comparing a market to an indicator like the (OBV) or relative performance (RS analysis).

The first example comparing the Dow Industrials and Transports is from 1980. There has been much discussion in the recent past about possible similarities between 1980 and 2012.

NEXT: An In-Depth Look at the Transports in the 70s

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In early 1978, the Industrials made lower lows, line a, while the Transports did not make new lows, line b. Then, in April 1978, the Transports closed above the highs from late 1977, point 1, and began a new uptrend.

It was not until June 1978 (point 2) that the Industrials confirmed this by closing above its highs from late 1977.

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Through late 1979, the Transports formed a series of higher lows and higher highs while the Industrials did not. Both averages rallied sharply in early 1980, as the Industrials rose 5.4% in the first six weeks while the Transports gained over 14%. Both averages then reversed course and dropped to new lows for the year.

The Transports held above the lows from late 1979, line d, and did not confirm the lower lows in the Industrials, line c. This was a positive sign, but it was then necessary for the averages to prove themselves by confirming a new uptrend.

By early May, the Transports started to rally, and in mid-July (point 3), the highs from early in the year, line f, were surpassed. The same week (point 4), the Dow Industrials confirmed the action in the Transports by also overcoming its previous highs at line e.

As I noted in a previous Trading Lesson three years ago, 1980 was not a year to sell in May, as both averages rallied into 1981. The Dow Industrials gained 41% from the March 1980 lows to the highs in May 1981, while the Transports were up 96% during the same period.

Both averages made higher highs in early 1981, so there were no divergences. In early July, 1981 (points 5 and 6), the Industrials and Transports violated their mid-May lows and began new downtrends that lasted until the summer of 1982.

The fact that the Transports did not make new lows with the Industrials gave traders and investors valuable information on which sector was likely to be the strongest.

NEXT:Transports and Industrials Flashed Critical Signals in 1998, Too

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In 1998, it was the Industrials that were stronger than the Transports. Stocks moved higher into July 1998, but then, growing concerns over the instability in Russia got the market's attention and helped trigger a correction.

On this daily chart, we can see that the Dow Industrials did make higher highs in July, line a, while the Transports made lower highs, line b. The failure of the Transports to confirm the action in the Industrials warned that the market was now vulnerable.

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On July 29 (point 1), the Transports closed below the June lows, line c. Then, four days later, on August 4, the Industrials closed below the June lows. This signaled the start of a new downtrend.

The selling was quite heavy in September and October and the Transports made sharply lower lows, line e. Since the Industrials were stronger at the July highs, it was not surprising that the Industrials did not make new lows in October, line d.

On October 15, point 3, the Industrials closed above the September highs, thereby signaling that a new uptrend was underway. It was not until November 2, point 4, that the Transports were able to confirm the action in the Industrials by closing above the September highs.

I also rely heavily on market internals like the Advance/Decline line, as well as volume in my analysis. The A/D line, in particular, can play a valuable role in confirming the action in the major averages.

The short-term trend analysis of the A/D line has done an excellent job of identifying market lows like the one last October and the recent market top.

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The length of the divergence, or non-confirmation, also provides important information about the magnitude of the rally or decline. In 2007, the Transports peaked in July and while the Industrials were making higher highs in October, line a, the Transports formed lower highs, line c.

In addition to the two Dow averages, I have also added the NYSE Advance/Decline line. The A/D line peaked in June 2007 and formed lower highs in July, as it did not confirm the new highs in the Industrials or the Transports.

As the Industrials were making significant new highs in October, line a, the A/D line was forming another lower high, line b. The four-month divergence suggested an intermediate-term top could be forming.

The lows associated with the panic selling in August 2007 made for an important level to watch, and the Transports violated those August lows on November 7, point 2. It was two weeks later, on November 21, when the Industrials also closed below the key August support, point 1. It was not until the middle of January that the A/D line finally broke below its key support at line d.

This discussion is particularly relevant to the market's status in 2012. On May 1 of that year, the Dow Jones Industrials made a high of 13,338, which was above the April high of 13,297, line a. The Dow Transports made a high of 5360 in early May, which was below the March high of 5389, line b.

This divergence was validated two weeks later when the Industrials closed below the March and April lows, point 1. This was confirmed by the action of the Transports, which also closed below support at point 2.

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Though this action confirmed the downtrend I had been discussing since April of 2012, the major A/D lines did not show long-term divergences like they did in 2007-2008 or at other major market tops.

I hope you have found this discussion to be beneficial and that you will keep both the Dow Industrials and Transports on your radar.

Now that I have clean data on both the Industrials and Transports going back to 1920, I will be exploring the concepts from this book in future articles. Even 80 years after its original publication, The Dow Theory does not seem overly dated, and I would encourage any students of the market to buy a copy.

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