A New Twist on an Old Theory is Signaling a 'Buy'

The Dow Theory is probably the first trading strategy ever described in detail. Charles Dow developed the Dow Jones Industrial Average (DJIA) and the Dow Jones Transportation Average (DJTA) to track economic trends and he soon realized these averages could be useful for timing stock market moves.


When both averages are moving up, the market is a buy, and sells are signaled when both averages are moving lower. Unfortunately, there are also times, like now, when no clear signal is being offered.
Up moves under Dow Theory are defined as new highs, and when an average reaches a new high, it is a buy. The chart below shows the DJIA signaled a new buy as it reached new highs in August. The DJTA failed to confirm that signal, and pure Dow Theory practitioners remain bearish based on a sell signal given in May when both averages fell to new lows. More recent market action has failed to deliver a strong buy signal and a divergence has formed where one indicator is bullish and the other is bearish.

While the Dow Theory looks solely at prices, the idea of using the industrials and transports can be applied in a number of different ways. Rather than waiting for Dow Theory signals, traders can apply indicators and develop trading strategies that take advantage of the trend with clear signals from indicators.

The chart below looks at the two indexes with a stochastics indicator. Here the trade signals are less ambiguous and, for now, a long trade in the transport sector seems like the best potential trading option.

The weekly chart shows that the DJTA signaled a buy in the stochastics indicator at the close of trading last week, while the industrials remain on a buy signaled a week earlier.

Among transportation stocks, railroads are the strongest sector and Genesee & Wyoming (NYSE: GWR) is the railroad company with the fastest growing long-term earnings. GWR operates railroads in the United States, Australia, Canada, the Netherlands, and Belgium. This geographic diversification is rare in the railroad industry and should help GWR maintain steady profits in a regional economic slowdown. The company has averaged earnings growth of about 17% a year in the past five years and is expected to continue growing earnings at that rate for the next five years.
GWR is among the biggest winners in the stock market during the past six months with a gain of more than 50% in that time. This has pushed the stock toward the initial price target projected from a cup-and-handle pattern. The next target from that pattern, a Fibonacci extension of the depth of the pattern, is at $86, offering a potential gain of 17% from current levels.

Initially, a stop-loss below last week's low at $67.50 should allow traders to benefit from an up move without accepting too much risk. Longer term, it could pay to remember that GWR has been a big winner in the past. Rather than taking short-term profits in the stock, it could be best to use a trailing stop in order to benefit from the trend as long as it lasts. The 26-week moving average (MA) offers a way to do this. If GWR moves above the initial target of $77, traders should use the 26-week MA as a trailing stop and exit when GWR closes below that average.

This trading strategy uses the idea behind the Dow Theory that the industrials and transports should confirm each other. But it adds indicators to offer timelier trade signals, which could improve on the profitability of the basic strategy.

Recommended Trade Setup:
-- Buy GWR at the market price.
-- Set initial stop-loss at $67.50
-- Set initial price target at $77 for a potential 5% gain
-- If target is hit, then raise stop-loss to the 26-week MA to participate in the uptrend as long as possible