Taking down the Dow Theory

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.

But there are reasons to be cautious about this relationship continuing. Some caveats to consider:

Prior to this year, the previous time the Dow Jones Industrial Average and the transportation index both closed at record highs was on July 19, 2007. At that point, the bull market had just three more months to run: the Dow peaked on October 9 of that year before starting its long, slow slide. And even between that July date and the eventual peak, the Dow industrials rose by only 1.2 percent. Suffice it to say that if this bull market has just three months to run with a 1.2 percent increase left in it, that would be tremendously disappointing.
One of the most prominent Dow Theory watchers, the newsletter editor Richard Russell, thinks the market landscape is so different these days that the old rules simply don't apply. "Both D-J Averages produced something never seen before, namely new highs during a post-crash upward correction," Russell wrote recently in his Dow Theory Letter. "My explanation of this unprecedented situation is that the advance to new highs was a direct result of never-before-seen manipulation by the Federal Reserve." Russell remains bearish despite the signals sent by the transportation index.
Finally, there's just not that much reason to think there's a unique interaction between the two indexes any longer. The initial idea was that when the people making the goods and the people delivering the goods are both doing well, the economy must be booming. But there are many companies among the Dow industrials these days that don't rely on the rail and shipping companies that dominate the transportation index. The Walt Disney Company doesn't deliver its goods and services by rail. United Health Group doesn't depend on trucking companies to keep its insurance clients happy. The interaction between the two indexes is not nearly as strong as it once was.

There were once very good reasons to believe in the Dow Theory, and it's not surprising that its correlations held up for most of a century. But most of those reasons don't exist anymore.

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