Are The Averages in Gear? by Richard L. Evans
What is Dow theory really indicating when the industrial and transportation averages are out of sync? Here's a Dow theory specialist to clarify.
One of Dow theory's main tenets and the basis of much modern-day technical analysis is the principle of confirmation. The confirmation theory originally took shape when Charles Dow first noticed that important market movements were preceded by joint confirmation of his two indices, the industrials and (at that time) the rails. Given that both indices represented at the time nearly all the important stocks, he reasoned, both should move together as a measure of breadth. Later, William Peter Hamilton further enhanced the confirmation tenet with underlying economic theory to the effect that the industrial average represented the production of goods and the rails the movement of goods, and when the averages were out of sync, the divergence reflected economic deterioration and were the harbinger of stock market uncertainties.
However, what started out as a simple observation in a Wall Street Journal editorial nearly 100 years ago has found its way into nearly all facets of modern-day technical analysis. Indeed, the confirmation/divergence principle is so strongly associated with so many developments in technical analysis that many investors today do not realize that confirmation was first popularized in the writings of Charles Dow almost a century ago. But the confirmation principle, based specifically on the Dow Jones industrial and (now) transportation averages, is still very viable as a gauge of the overall market, if not more so, for investors of all levels of sophistication.