Updated: Aug 22, 2019
The idea of using the price action of one index to confirm the trend of another index is not a new one. Technical analysis pioneer and founder of the Wall Street Journal, Charles Dow, created two indices for that very purpose. The Dow Jones Industrial Average is still a popular, albeit not fully representative, barometer of the US stock market, as well as the wider economy. Dow created this and another index, the Dow Jones Railroad Average (now known as the Dow Jones Transportation Average), which he would use in conjunction with the Industrial Average.
The idea was that new highs in the Industrial Average would be indicative of growing demand for goods in the economy. This trend would have to be confirmed by new highs in the Railroad Average before buying stocks since truly strong growth in the economy would also require an increase in railroad transportation of goods across the country. If the Industrial Average made new highs but the Railroad Average did not Dow suggested that the uptrend could not be confirmed as the weakness in the Railroad Average acts as a warning of fragility in the rising industrial stocks.
In today’s markets, the idea does not apply in exactly the same way because many modern firms sell internet-based goods or services, neither of which necessarily require physical transportation. However, with today’s range of indices available, the philosophy can be applied in a slightly different way. Smaller capitalisation averages could be used to confirm larger capitalisation ones, for example. Also, technology indices can be used to confirm general averages since an expanding economy also causes an increase in demand for technology. The examples below explore how a pair of indices confirm each other in modern markets.
Figure 1 shows the S&P 500 index in blue and the Russell 2000 in red. To the left of the chart, both markets determine resistance in the coloured boxes. These are the levels of resistance which must be broken to enter an uptrend. The S&P breaks through resistance in February 2012. However, the breakout was unconfirmed by the Russell 2000 which failed to make new highs at the same time. Had you bought the S&P at this breakout, you likely would have been stopped out when it retraced a little over 6%.
The confirmation from the Russell 2000 came later in December of 2012. Once that broke resistance, both markets had done so and thus the uptrend had been confirmed. Going long here would have given a much stronger position in an uptrend which was generally uninterrupted for two and a half years.
The same thing happened with the same two markets four years later. As shown in figure 2, the S&P broke above resistance first in July 2016, but it was not confirmed by the Russell until four months later in November. Once the Russell confirmed, the rally in the S&P really kicked off.
The chart in figure 3 shows a different scenario. The same two markets, S&P 500 in blue and Russell 2000 in red are shown. Both determine clear resistance levels at the same time around July 2007. The S&P breaks above in October 2007 which is enough to warrant entering a long position for traders buying breakouts without cross-market confirmation. Those who enter get badly burned, as the financial crash wipes out over 50% of the S&P’s value.
Crucially, the Russell never broke above resistance in figure 3. It never confirmed the uptrend in the S&P and it never gave permission to enter to traders relying on a strategy that incorporates cross-market confirmation. Using this confirmation could have saved traders from entering a very bad position.
Fast-forward to today, and something familiar is happening. Figure 4 shows the markets at the time of writing.
The S&P broke above to all-time highs in June. The Russell is yet to confirm and is still a considerable distance from resistance. What does this mean for the S&P? What would Charles Dow say looking at this chart? He would probably recommend a cynical view of the S&P’s bullish breakout signals because the trend is, currently, not strong enough to be confirmed by new highs in the small capitalisation index.
It seems that Dow’s idea of using one index to confirm the trend in another still carries at least some practical applicability today. Building a trading system based on cross-market confirmation alone is unlikely to bring you wildly successful results, and you may find yourself spending an awful lot of time sitting on the sidelines waiting. However, you can use this technique to give you much more conviction in the strength of a trend as it develops, and it may give you the cynicism needed to avoid getting caught out by the next major crash. The value of that should not be underestimated.