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I can’t necessarily speak to others’ experiences, but whenever I have gotten either too confident or complacent about markets, I’ve been hit on the head with a 2×4.  The old saying on Wall Street is: “Never confuse genius with a bull market.” A long bull market will eventually convince most of us that we are brilliant.  Then we get humbled — hence the 2×4.

We have enjoyed a very robust, long bull market, and the sailing still looks pretty good.  But let’s not be complacent and lose touch with the reality that returns are ultimately linked with risk. We humans tend to bask in the good feelings of high returns and lose sight of the risk.

The market is expensive and highly concentrated.  The economy is not balanced.  Half of personal consumption comes from just 10% of the population — the very well-off who own the rapidly appreciating assets, mostly stocks and real estate. This means that if stocks and real estate were to falter, it would immediately affect the psychology and buying power of this cohort, with a commensurate hit to consumer spending, which accounts for 70% of the economy. The ripple effect could be substantial.

The state of public finances is grotesque, and we wonder whether the government can pull off rescue operations without driving deficits so high that markets lose confidence in the government itself.

But, as mentioned last time, sentiment is not extreme, and technical momentum remains good.  But it is also true that valuation is high, market concentration is extreme, and leverage (not just margin debt but also option activity and leveraged ETFs) is high.

So, we remain largely long the market, but it is time to “keep your head on a swivel” and stay alert to warning signals.

One of these alerts comes from technical analysis, which is the study of price patterns and history.  Within this body of knowledge is one of the oldest technical approaches called Dow Theory.

Charles Dow, one of the founders of the Dow Averages, the Dow Jones company, and the Wall Street Journal, developed this market theory around the turn of the 20th century that now bears his name.

Later, his work was taken up by Robert Rhea and William Hamilton.  Hamilton was the fourth editor of the Wall Street Journal. 

Here is the cover of the vintage 1922 edition:

By the 1950s and 1960s, this theory was further elaborated upon by E. George Shaefer and Richard Russell.

Richard Russell started writing about the market around 1958, was a frequent contributor to Barron’s Magazine, and also wrote an independent newsletter until he died in 2015.  Thus, Russell wrote professionally about the market for 57 years, the longest streak recorded.  He influenced many technical stock analysts and general readers, including yours truly.

While I did not know him well, we did speak on occasion, and he was a speaker at conferences I was involved in. He was a very sharp fellow and you can’t write for subscribers for 57 years without being correct most of the time. If he were an idiot, who would subscribe to his letter?

In addition to his views on the stock market, Richard Russell is also credited with being one of “the original gold bugs.”  Russell started recommending gold as a portfolio diversifier back in the early 1970s, long before it was popular. 

Unlike many, he could be bullish on stocks for the long term and still invest in gold.  Many others found the two arguments totally incompatible, but not Russell.  One reason is that he was always guided by price trends, regardless of theoretical debates.

What is Dow Theory?  Like most technical systems, it makes some crucial assumptions you either accept or do not. Some of these are:

All available information—economic data, news, investor sentiment—is already reflected in stock prices. New information only affects prices when it emerges.

Although practitioners never refer to Hayek, to my mind, their price theory is very similar to that of the Nobel Prize winner in Economics.

Hayekian price theory (referring to the work of economist Friedrich Hayek, particularly his 1945 essay “The Use of Knowledge in Society”) does indeed suggest that prices aggregate and reflect all relevant known information dispersed across society—though with a nuanced emphasis on the dispersed, tacit, and often inarticulate nature of that knowledge, rather than a perfect or fully “knowable” snapshot in the modern Efficient Market Hypothesis (EMH) sense. This aligns closely with Dow Theory’s first principle that “the market discounts everything,” as both views treat prices as a summary mechanism for economic reality.

Dow Theory then breaks down the market action into three trends:

• Primary trend: The major, long-term direction (bull or bear market, lasting months to years).
• Secondary trend: Intermediate corrections against the primary trend (lasting weeks to months).
• Minor trend: Short-term fluctuations (days to weeks), often noise. Trends persist until clear signals reverse them.

The stock market has “phases”:

• Accumulation: Savvy investors buy undervalued stocks very early, coming off a significant bottom.
• Public participation: Broader market joins, the general public and institutions come in, driving prices higher (or lower in bears).
• Distribution: Smart money senses overvaluation and waning momentum and sells to the public at peaks.

Dow theory also has a concept of “confirmation”.

The primary focus here is on the DJIA (industrials) and the Dow Jones Transportation Average (DJTA). A trend is only valid if both indices move in the same direction. For example, in a bull market, new highs in the DJIA must be matched by new highs in the DJTA to confirm the bull market’s strength.

Dow felt that the Transport averages were essential to confirm the other popular index because the Transports (railroads, trucking, airline and air freight, ships, pipelines, etc.) were more closely associated with the “real” economy of production and distribution, not just financial speculation and money lending.

Also, in terms of “confirmation”, price movements must be associated with volume to be considered valid. Rising prices (or falling prices in a bear market) should be accompanied by increasing trading volume to validate the move. Divergences in volume signal potential weakness.  A market, for example, that advances on low and declining volume would be suspect.

Thus, divergence becomes a key concept.  In a sense, divergence is a lack of confirmation.

Finally, Dow Theory emphasizes the persistence of the price trend.  As Russell used to say, “A trend in force is a trend in force until proven otherwise.”

This is one of the reasons we have remained bullish in the column, despite all the justifiable reasons to worry.  Respect and ride the trend until it is exhausted and reverses.

Like all technical systems, it is not perfect, and opinions about the signals can vary. But one of the most important —and the one that should gain our attention — is the notion that when the average is not confirmed by the other, we should at least become alert to trouble.

Importantly,  the track record of Dow Theory is both long and good. Here’s a snapshot of key historical sell signals at bull peaks, showing the theory’s consistency across eras (from industrial booms to tech bubbles). Note the average bear drawdown post-signal was ~35%.

You likely have heard that stocks have reached new highs.  This includes most of the major averages, such as the Dow Jones Industrial Average and the broader S&P 500. But what you may not know is that the Transport average has not gone to a new high.

Above, we show market action for the past two years.  Note the Transports are in green.  The transports were doing quite well, often better than the Industrials.  Both indices dropped sharply last April, and then both recovered together.  But in late July and August, something started to go wrong, and they began to diverge sharply.

It has now become a yawning multi-month gap.  The Transports are not confirming the new high in the Dow Industrials. 

Now, maybe the Transports will catch up and reconfirm the trend, but if they don’t, at least those who think Dow Theory has something to teach us will be pretty worried.

We read some analysts who contend that the Dow Theory applies only to earlier periods, when industry was the dominant driver of the economy. Today, most of the economy is processing information we are told, so the Transports don’t mean much at all. After all, you don’t get TikTok off a truck.

But where is all the power coming from to power the AI centers driving growth in the Magnificent Seven that are pushing our stock market upward?  It comes by ship, by rail, by truck, and certainly by pipeline.  And how about all the building materials for the AI build-out?  What about all the commodities in components that must be processed, manufactured, shipped, and assembled?

And what is wealth for, if not to increase consumption?  Sure, you order electronically from Amazon, but how does it get to your door?  And how did all the stuff get into their warehouse in the first place?

In short, don’t be too quick to buy into the notion that transporting goods is no longer critical. Thus, the actions of stock indices related to real production and distribution should NOT be ignored in the age of “digital commerce.”

And it is worth noting from the table above that Dow Theory was pretty damn good, helping investors avoid the recent crashes in our “modern” era.

So, this divergence is now worth watching, unless you like getting hit upside the head by a 2×4.

But a warning flag is not a sell signal.

While DJTA hovers ~3% below its July peak near 15,864 vs. 16,373, it is a warning flag, not a full sell signal. Dow Theory is conservative: It assumes the primary bull trend persists until both averages provide unambiguous reversal evidence. A mere divergence questions the rally’s underlying strength but doesn’t flip the script to bearish.

A full-blown sell signal is complex and a discussion for another day. We will keep you up to date as things progress.

*****

Charts created by the author courtesy of Stockcharts.com

Image Credit: Wikimedia Commons, GROK AI image generator