Dow Theory Put To The Test!
by Ian Harvey
October 01, 2012
The Dow Jones Transportation Average (DJT) has been a popular topic lately. Dow Theory, (named after Charles Dow, founder of The Wall Street Journal) states that the transportation index should confirm a rally in the industrials. In other words, if the Dow Jones Industrial Average (DJI) is going higher, then the transportation index should also be going higher. If the averages are diverging, then a change in the trend is more likely to occur. Over the past few months, the DJI has rallied pretty strongly, while the transports have lagged. Therefore, it is worth observing the numbers to confirm the idea behind Dow Theory, and figure out what these divergences have meant in the past.
‘Dow Theory’ is a theory which says the market is in an upward trend if one of its averages (industrial or transportation) advances above a previous important high, it is accompanied or followed by a similar advance in the other.
The theory also says that when both averages dip below previous important lows, it's regarded as an indicator of a downward trend.
Divergence During A Rally
The chart below shows the current deviation between the two indexes. Over the past few months of the broader Dow's rally, the transportation index has been heading lower. In fact, the Dow managed a gain of nearly 8% during a recent three-month period, while the transports were negative over this same time frame.
The table below shows how the Dow has performed over the next one-, three-, and six-month periods after it gains 8% during a three-month span, which takes into account all such returns since 1950. It breaks the returns into whether the transportation index was: down; up but underperforming the Dow; and finally, up and outperforming the Dow.
This analysis validates the Dow Theory, as the industrial index averages a loss over the next three months when the transports are down during the rally. The Dow typically does best going forward when the transports outperform a strong market.
A Different Economy
A point often raised is that we have a different economy now than when Dow Theory was most popular. Manufacturing and shipping is not as critical to the economy today as it once was, now that we're in the digital age. Therefore, by using the same method of analysis as used above, but taking into account only data since 1990, certain consequences can be determined. Since 1990, there have been nine occurrences when the Dow rose 8% in a three-month time frame, but the transports were down.
Over the next three months, the Dow averaged a loss of more than 4%, as shown in the table below, and only two of those returns were positive (not shown). If the transports are up during the broader Dow's rally, then the market fares much better going forward. So, even in the new economy, these numbers suggest that the Theory still holds up.