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A new Dow Theory signal was given after Wednesday’s close.

It provides information about the health of the economy..

The signal also provides some insight into the odds of the next bout of stock market weakness taking the form of a correction or bear market.

Charts Monitor, Rather Than Dismiss Fundamental Data

Critics of technical analysis often mistakenly believe that using charts discounts the importance of fundamental data, such as earnings, employment, and economic growth. Charts allow investors to monitor the aggregate investor interpretation of all the fundamental data. Said another way, charts are efficient tools used to monitor vast amounts of fundamental data, which is important since fundamentals ultimately determine which assets classes will perform best. When the economy is healthy, stocks tend to beat bonds. When economic fear dominates, bonds tend to beat stocks. In this article, we will cover the latest signal from the markets that came on July 16.

Dow Theory Is Based On Economic Common Sense

Dow Theory is based on a series of Wall Street Journal articles written by Charles Dow. The basic tenets of Dow Theory are easy to understand. Charles Dow believed that:

  1. In order for industrial companies to increase their earnings, they had to produce and sell more goods.
  2. If industrial companies are selling more goods, then transportation companies must be delivering more goods to retailers and wholesalers.
  3. Therefore, in a healthy economy, both industrial companies and transportation companies should be experiencing revenue growth.
  4. If industrial and transportation companies are growing their revenues, then the industrial and transportation stocks should be attractive to investors.
  5. If industrial and transportation companies are doing well and are attractive to investors, both the Dow Jones Industrial Average and the Dow Jones Transportation Average should be making new highs in unison, serving to confirm a healthy economy.

Behind The Averages

After reviewing the companies in the industrial and transportation averages, it is easy to see why they represent logical vehicles to monitor the pulse of the U.S. economy. In 2014, our economy is driven by more than just industrial or manufacturing companies. The present day Dow Jones Industrial Average contains traditional producers, such as IBM (NYSE:IBM), 3M (NYSE:MMM), Boeing (NYSE:BA), Chevron (NYSE:CVX), and Johnson & Johnson (NYSE:JNJ). However, the Dow (NYSEARCA:DIA) also contains Visa (NYSE:V), Goldman Sachs (NYSE:GS), and American Express (NYSE:AXP), since the present day economy relies heavily on the financial sector. The Dow Jones Transportation Average (NYSEARCA:IYT) still has railroads, such as Union Pacific (NYSE:UNP) and Norfolk Southern (NYSE:NSC), but it also contains more modern logistics companies, such as United Parcel Service (NYSE:UPS), Fed-Ex (NYSE:FDX), and J.B. Hunt (NASDAQ:JBHT).

Just Reconfirmed Primary Bull Market

If investors believe industrial and transportation stocks are healthy and thus, attractive investments, that speaks to demand. When demand is strong, stock prices rise. Despite the recent Fed/Ukraine volatility, the Dow Jones Industrial Average posted a new closing high this week. Notice the slope of the blue 50-day moving average in the chart below; you can compare it to the early stages of a 2011 correction in stocks and to the 2008-2009 bear market later in the article.

Similarly, the Dow Jones Transportation Average also posted a new high on July 16. Again, note the look of the blue 50-day moving average.

2011: How Can This Help Us Manage Risk Today?

If Dow Theory offers a way to monitor the aggregate interpretation of the economy, earnings, and central bank policy, then we would expect charts of the DJIA and DJTA to be helpful in terms of managing investment risk. Since a picture is worth a thousand words, when the Dow's 50-day rolled over in 2011 (see orange arrows below), the index dropped an additional 16%. Notice how the Dow failed to make a new closing high before the big reversal in 2011. As of July 17, the 2014 Dow chart looks much better (slope of 50-day is up, recent higher high).

2007-2009: Economic Pessimism And Investor Fear

Similar economic warnings came in 2007 and 2008 (see orange arrows in chart below). Notice during the 39% drop in the Dow in 2008 the 50-day never gave a "things are improving" signal, meaning it was helpful from a cash-redeployment perspective. The Dow was not making new highs; instead it was making a series of lower lows, which reflected a period of economic pessimism and investor fear. The 2014 chart looks much better, which is indicative of more favorable economic expectations.

The differences are easy to see side-by-side. The stronger bullish conviction tells us even if stocks pull back in the short-run, the odds are good that buyers would step in and attempt to test the recent highs. Reversals tend to be a process rather than a one day binary event. The charts below speak to probabilities.

The Fed Still Big Part Of Fundamental Equation

Anyone that has followed the markets closely, especially over the last four years, knows that all things being equal the stock market is not fond of any Fed move that slows the printing presses. Thursday's not too hot, nor too cold data on the economic front most likely keeps a 2015 rate hike on the probability table. From Reuters:

Rising inflation pressures could push the U.S. Federal Reserve to raise interest rates as early as the second quarter of next year, according to a Reuters poll of analysts. America's jobless rate sank to almost a six-year low in June and consumer prices posted their largest rise in May in more than a year, bolstering the belief that the U.S. economy is turning a corner. Now many Fed watchers are bringing forward forecasts on the timing of when the central bank will raise interest rates. "All things considered, there is now an increased risk of an earlier first rate hike," economists at Bank of America Merrill Lynch said in a report.

Investment Implications - Time To Pay Closer Attention

Does the recent Dow Theory bullish confirmation mean it is all fun and games for the economy and stock market (NYSEARCA:SPY)? No, it simply tells us the market is currently healthy, and the next bout of significant weakness is more likely to be a correction, rather than a full blown bear market. Notice, a correction remains a possibility. As the godfather of technical analysis noted on Twitter, this week's signal keeps the longer-term bullish case intact.

For Further Study

Since the markets are nervous about rising interest rates, it may be prudent to brush up on risk management strategies:

  1. How To Monitor The Risk Of A Midterm-Election-Year Stock Correction
  2. 5 Reasons Your Simple Bear Market Plans Could Backfire
  3. The 2 Most Important Questions For Investors

Disclosure: The author is long SPY, IYT, DIA. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.