What can Dow Theory tell us?

Even if you're sceptical about technical analysis, it's worth understanding what other people are getting from it.

Charles Dow was the founder and first editor of The Wall Street Journal (WSJ). In 1896 he invented the Dow Jones Industrial Average (DJIA), an average of the closing share prices of 12 of the most important listed companies in the US, calculated daily. It provided WSJ readers with a way to track stockmarket activity, and eventually evolved into today's 30-strong Dow Jones index. Dow was also extremely interested in markets, and his regular columns for the WSJ were collected and formalised into "Dow Theory" after his death. It has become one of the most widely followed and influential technical analysis theories in the markets.

In recent weeks, Dow Theory has featured heavily in the news markets in the US have been falling since October, and investors want to know if we're seeing the start of a full-on bear market, or just another chance to "buy the dip". Dow Theory promises to help. Dow actually invented two indices the aforementioned DJIA, and also the Dow Jones Railroad Average (now the Transportation Average, or DJTA). The idea was that if there is healthy demand for the goods being made in factories, then that should also be good for the companies taking those goods to market. But if one index was rising but the other falling, for example, then that could be an early warning sign of a turn in the economy. And if both fell together consistently, then it's a sign that the outlook is turning grim.

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What's drawn attention now is that both the DJIA and the DJTA are making what's known as "lower highs" and "lower lows" ie, when they fall, they fall below their previous low, and when they rebound, they stall at a lower ceiling than before. That suggests both have moved into a bear-market trend, which in turn suggests the path of least resistance is now lower.

You might view technical analysis as a lot of rubbish. It often baffles investors who would rather focus on the fundamentals, and the wide range of interpretations mean it's as much art as science. However, even if you don't want to start drawing lines all over charts, it's worth being aware that plenty of other people do, and that Dow Theory has more followers than most.

The other point for sceptics to remember is that momentum (buying what's going up and selling what's going down) has a long history of working. You might struggle with the logic behind that, but whether you like it or not, it's a widely respected "factor" (see below) in equity markets. So there is a great deal of value in ascertaining whether the overall market trend is higher or lower. Whether you felt you needed a signal from Dow Theory to tell you that after the last few weeks is another matter, of course.