Dow Theory Buy Signal Confirms Market Rally Is Real

| About: SPDR Dow (DIA)

Summary

The Dow Transportation Average hit a new high on December 7, 2016, confirming the market is bullish according to Dow Theory.

Investors can now have more confidence that the post U.S. presidential election rally could last a long time.

The best stock groups to buy aren't necessarily in one of the Dow indices, however.

There has been a lot of hand wringing about the current rally in U.S. stocks, but the rally just got some major confirmation from the venerable Dow Theory, which flashed a buy signal for the first time in two years. Bulls can now be more assured that the current post-election rally is real and might last a good while longer.

The Dow Theory is one of the oldest rules for stock market behavior in the U.S. market. Its origins date back to as early as the end of the 1800s, although the details weren't fully published until 1932. The theory makes a great deal of sense for an industrial economy because it assumes that if goods are produced, they need to be shipped. Therefore, movements in the Dow Industrial Average (dating back to 1896) should be confirmed by the Dow Transportation Average (dating back to 1884 and originally referred to as the Rails). Since the U.S. economy has long since segued into an information economy and the Internet has been publicly available for over 20 years, the Dow Theory now has many detractors, although it still has its advocates who follow it closely. More importantly, it still seems to be working.

In simplest terms, the Dow Theory states that if the Dow Industrials hits a new high, so should the Dow Transportation Average. The theory does not specify the time frame needed for this to take place. Some sources describe it as "a reasonable time." So, this means the theory requires interpretation and waiting and seeing. Eventually, one of the indices will drag the other up or down and they will move up together. As of December 7th, the two indices are now both in confirmed rally mode.

Dow Industrial Average Three Years Daily

As can be seen from the chart above, the Dow Transportation Average made a high in November 2014. At the time, its highest price was 9,310.22. The Dow Industrials hit a series of new highs before and after. The last high reached for the Industrials was in May 2015. The Transportation Average didn't confirm that high by reaching a new record itself. Subsequently, the Industrials fell (as would be predicted). It then reached a new high in July 2016. Since the Transportation Average was well off its 2014 peak at the time, market observers didn't think it likely that it would be able to confirm the recent Dow Industrials bullish behavior. But they were wrong.

Dow Transportation Average Three Years Daily

After the U.S. presidential election, the Dow Transportation Average had a big rally like many other (but not all) stock groups. Its final price on December 7th was 9,371.61, measurably above its 2014 high. The rally in the Industrials was finally confirmed after two years, giving investors a green light to buy stocks. This doesn't mean just any stocks can be bought, nor that the Dow is the best index to buy either.

As I've discussed elsewhere, the best performing group of stocks in the current post-election rally are small caps. For a detailed discussion of how various parts of the market have reacted after the election see here and here. In the one month following the presidential election, small caps have rallied more than twice as much as the Dow Industrials. The Transports have done almost as well as small caps, however.

U.S. Stock Indexes Performance In Month Following the Presidential Election


Red line is the small cap Russell 2000, gold line Dow Transportation Average, blue line Dow Industrials, orange line NASDAQ, Black line S&P 500

There are a number of ETFs that bullish investors can use to take a position in a broad-based transportation stock portfolio or in small cap stocks. For the transportation stocks, investors can buy and sell: IYT or XTN. For small-cap stocks, investors can choose among: IWM, IJR, VB, SCHA, XSLV, FYX, VTWO, RWJ, PRFZ, TWOK, SLY, VIOO, and DGRS.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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