How This Classic Market Theory Can Warn You of Big Turns

Dow Theory is a time-honored market analysis tool. Its name comes from Charles H. Dow, co-founder of The Wall Street Journal.

In fact, The Wall Street Journal provided a capsule summary :

Dow Theory holds that any lasting rally to new highs in the Dow Jones Industrial Average must be accompanied by a new high in the Dow Jones Transportation Average .... When the transport average lags, it can presage broader stock declines.

In the Wall Street classic Elliott Wave Principle, Frost and Prechter called Dow Theory the "grandfather" of the Wave Principle:

Both [the Wave Principle and Dow Theory] are based on empirical observations and complement each other in theory and practice.

Critics of the theory say it's no longer relevant. They argue that today's economy is less dependent on transportation and more on technology.

But EWI's analysts say this historical indicator is still highly useful to investors.

The Elliott Wave Theorist showed charts of two historic bear markets, and both sported dramatic Dow Theory non-confirmations. Here's the first one (N/C stands for non-confirmation):

You'll notice that in 1999-2000, the transports topped about eight months ahead of the Industrials. Starting in January 2000, the Industrials slid some 40% through October 9, 2002.

In 2007, the transport's peaked about three months before the Industrials. The 2007-2009 bear market was the worst since the Great Depression. The Dow Industrials lost 54%.

A Dow Theory non-confirmation does not accompany every stock market downturn, but the historical record shows that it does attend the start of every big bear market.

With that in mind, our April 27 U.S. Short Term Update called attention to Dow Theory and showed a chart that is jam-packed with important details that every investor should know.