One of the longest-lived theories about the stock market is the so-called Dow Theory, which holds that when the Dow Jones Industrial Average and the Dow Transportation Index are making new highs in lockstep, they are signaling not just a bull market but one with real staying power. The idea is that once the industrial average reaches a new high, the transportation index would confirm that trend by reaching a high of its own.
With the Dow cresting new records — and the lesser-known Transportation Index right alongside — this theory has gotten quite a workout in the financial press recently. The Dow Jones Transportation Average has been on a tear, closing at new all-time highs this week. So far this year, transports are leading the gains, up nearly 15 percent compared to a nearly 8 percent increase for the industrials.
But there are good reasons to be skeptical of the Dow Theory. Yes, it has held true through much of the modern history of the stock market, but that “truth” hasn’t been nearly as solid as some of its proponents would have you believe.
Dow Theory dates back to a gentleman named William Peter Hamilton, who took over as editor of the Wall Street Journal upon the death of Charles Henry Dow himself back in 1902. Hamilton explained the theory in his 1922 book, “The Stock Market Barometer,” and it quickly became received wisdom among the investing mavens of the day. In 1932, an acolyte of Hamilton’s named Robert Rhea wrote, “The fluctuations of the daily closing prices of the Dow Jones rail and industrial averages afford a composite index of all the hopes, disappointments and knowledge of everyone who knows anything of financial matters, and for that reason the effects of coming events (excluding acts of God) are always properly anticipated in their movement.”
That’s pretty strong stuff, and for a long time, the Dow Theory has indeed anticipated the market. A 1997 academic paper authored by economists from Yale and NYU found that “timing strategies based upon the Dow Theory yield high Sharpe ratios and positive alphas.” According to Morningstar Commodity Data, there have been only three instances in history when the Dow industrials had a negative year after the Dow transportation index had performed well in the first two months of the year.