Monday, January 11, 2010

Index Confirmation

The origin of technical analysis, or forecasting future price movements through patterns and trends, can be attributed to a few individuals. Charles Dow is generally considered to be the founder of modern technical analysis due to his work at the end of the 19th century. He wrote editorials in the Wall Street Journal which have now become collectively known as Dow Theory (he did not use this title). The theory assisted Charles in creating his famous indexes – the Dow Jones Industrial Average and the Dow Jones Transportation Index (formerly known as the Dow Jones Rail Index). There are six basic tenets of Dow Theory, and the two previously mentioned indexes are used to analyze one of them.

One important condition under Dow Theory is that markets must “confirm” each other. Dow argued in his editorials that markets reflect business conditions and by analyzing the markets, one could determine the likely course for stock prices. Dow stated that if business conditions are good, then companies will produce more goods. Then they would have to ship more goods to consumers by using the rails, or any other transportation method. Therefore, the two averages that he created will move in the same direction to confirm an existing trend. If the averages do not confirm, or move in the same direction, then the prevailing trend should be questioned.

The chart below shows the Dow Jones Industrial Avg. (white line) and the Dow Jones Transportation Index (brown line) from September 2009 through today. For roughly two months, the DJIA traded in a range between 10,300 and 10,500, but broke above the resistance line in red at the end of 2009. A few weeks later, the Transportation Index created a range between 4,100 and 4,200, but recently this index also moved above resistance (green line). Therefore, the two averages have “confirmed” each other, which tends to be a reliable signal that the existing trend will continue. Of course, this is only one of the six basic tenets!