By Chad Langager and Casey Murphy, senior analyst of ChartAdvisor.com
Under Dow theory, a major reversal from a bull to a bear market (or vice versa) cannot be signaled unless both indexes (traditionally the Dow Industrial and Rail Averages) are in agreement.
For example, if one index is confirming a new primary uptrend but another index remains in a primary downward trend, it is difficult to assume that a new trend has begun.
The reason for this is that a primary trend, either up or down, is the overall direction of the stock market, which in Dow theory is a reflection of business conditions in the economy. When the stock market is doing well, it is because business conditions are good; when the stock market is doing poorly, it is due to poor business conditions. If the two Dow indexes are in conflict, there is no clear trend in business conditions. (For related reading, see Forces That Move Stock Prices.)
If business conditions cause the major indexes to travel in opposite directions, this disparity suggests that it will be difficult for a primary trend to develop. When trying to confirm a new primary trend, therefore, it's vital that more than one index shows similar signals within a relatively close period of time. If the indexes are in agreement, it is a sign that business conditions are moving in the indicated direction. Thus, rising indexes signal a new uptrend.
InsightsLearn about the foundation upon which technical analysis is based.
InvestingAlthough the DJIA only includes 30 stocks, it can tell you a lot about the market as a whole.
InvestingFind out how this financial visionary helped everyday people enter the world of finance.
InsightsThe Dow Jones Industrial Average (DJIA) continues to be an important indicator of the economy, though some say the DJIA doesn't have the same import as it once did.