Dow Theory : Signaling Troubling Divergence

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07/03/2017 | 12:10 pm
Dow Theory contains several basic tenets of stock price movements, first observed by Charles H. Dow in the 19th century. One key element of Dow Theory is that stock market averages must confirm one another.

In Dow’s time, the U.S. was a growing industrial power (with a relatively small service sector).  As factories had to ship their goods to market, usually by rail, transportation was a crucial part of the economy.   For Dow, a bull market in industrials could not occur unless the railway average rallied concomitantly.  In sum, confirmation of a rising trend in the Dow Industrials and in the Dow Transports was a sign of a healthy economy.  On the other hand, when the performances of the averages diverge, it is a warning that change is in the air.

Despite the tertiarization of the U.S. economy, many technicians still follow this Dow tenet. Since mid-June, the Dow Industrials and Transportation Averages have been diverging. While this divergence may merit watching, we are not particularly worried about this Dow Theory warning.
 


 

Of greater concern today is the divergence of technology with the Dow Industrials.  Technology companies make up almost 20% of U.S. total market capitalization and play a leading role in an overwhelmingly service-based economy (quite unlike in Dow’s era).  Much more than the small non-confirmation developing between the Dow Industrials and Dow Transports, investors should monitor closely the growing gap in the Dow Technology Index with the Dow Industrials shown below.  While the odds likely favour a bounce-back in technology shares, should this divergence persist we would view the non-confirmation of tech shares as a warning sign for the overall stock market.

 

Owen Williams
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