Recent stock market action warrants the review of Dow Theory. On December 8, 2016, the Dow Jones Transportation Average increased above the previous peak set in December 2014. This change in the Transportation Average confirms the new highs established by the Dow Jones Industrial Average.
We’ve canvassed various articles referring to the recent Dow Theory signal and have pointed out the myths and facts.
Myth: “The theory makes a great deal of sense for an industrial economy because it assumes that if goods are produced, they need to be shipped. (Montgomery, Daryl. “Dow Theory Buy Signal Confirms Market Rally Is Real”. SeekingAlpha.com. December 8, 2016.).”
Fact: "The stocks of trust companies and banks are simply industrial stocks... (Dow, Charles H.Wall Street Journal. Review and Outlook. October 12, 1900)."
NLO Analysis: Little is understood about what Charles H. Dow said when he contrasted the performance of industrial stocks to transportation stocks. This leaves investors with the impression that if the U.S. is no longer an industrial economy then Dow Theory has little or no relevance in this modern age. Dow makes is abundantly clear that seemingly esoteric businesses like banks, insurance companies and even internet companies are, in fact, industrial companies.
Myth: “…Dow Theory Signals Buy. (Eisen, Ben. “Reasons for Caution Even as Dow Theory Signals Buy” Wall Street Journal. December 8, 2016.).”
Fact: "What we need are soulless barometers, price indexes and averages to tell us where we are going and what we may expect. The best, because the most impartial, the most remorseless of these barometers, is the recorded average of prices in the stock exchange. (Hamilton, William Peter. The Stock Market Barometer. Harper & Brothers. 1922. page 4.)."
NLO Analysis: Dow Theory does not give buy or sell signals. As a barometer, it merely indicates the direction that the stock market and economy may go three to nine months into the future. Those who take bull market indications as “buy” signals still need to be well versed in understanding values and its role in the selection of stocks. If a person not versed in values believes that a bull market indication means that they can haphazardly buy stocks then they are most likely to suffer severe losses and quickly become disenchanted with investing in stocks.
Myth: “Market watchers who look for parallels in the performance of both indices [Dow Jones Industrial Average & Dow Jones Transportation Average] could see the transports reclaiming a closing high as a bullish sign that the market's "Dow Theory" is in play, prompting investors to push the stock market even higher. (Valetkevitch, Caroline. “Dow transports set closing record high after 2-year wait”. December 7, 2016.).”
Fact: The following excerpts from the Wall Street Journal outline Dow’s theory on the role of the industrials as it originally was stated:
“This is preeminently the period of industrial speculation, yet the creation of industrial stocks has become pronounced only within a year…it follows that there must be a very strong body of [venture] capitalists prepared at present to resist anything like a collapse in the industrial market and to promote by every means in their power firm or advancing prices for the market as a whole. and this effort on their part is being powerfully supported by the excellent conditions of practically all branches of trade. (Dow, Charles H. Review and Outlook. Wall Street Journal. April 22, 1899.).”
Our interpretation of the preceding quotes is that industrial stocks were, in 1899, considered to be the equivalent to modern small cap stocks which are more speculative in nature and often prone to manipulation and collapse. The best confirmation of this concept is found in the following New York Times quote:
“Our London correspondent, in yesterday’s Financial Supplement, gave expression to the feeling which the English investor or speculator very naturally has as to the securities that usually go under the title of industrials in our markets. It is one of distrust and hesitation. It would be very strange if it were not. As to the investor, we suppose that no one on this side of the water would claim that our industrials, taking them ‘by and large,’ the older with the new, the more solid with the more inflated, can be regarded as ‘investment’ securities. (New York Times. “The Industrials and The Boom”. March 14, 1899. page 6.).”
NLO Analysis: By most measures, the New York Times article, from one month earlier in 1899, confirms our view that industrial stocks were of low quality. Now we need to see what Dow intended for the role of transportation and industrial stocks.
“…railway [transportation] stocks generally occupy a position much stronger than that held by the industrials. The growth of the business of the country accrues on the old stocks [transportation stocks]. The Industrial list occupies an entirely different position. There has been a very large creation of securities [initial public offerings]. Stocks have been bought on very limited information as to the value of the property acquired. Attack of these stocks brings selling from those who know little in regard to the worth of what they have bought; also from those who got in at low figures [company insiders] and who propose to get out as well as they can. This is the ideal condition for bear attacks, checked only by the possibility of not being able to borrow stock [for short selling]. The thoughtfulness of promoters [investment banks] in providing ample capital relieves this danger to great extent and will relieve it altogether when the new Industrials come to be distributed. (Dow, Charles H. Review and Outlook. Wall Street Journal. May 31, 1899.).”
Our view is that Dow’s theory was intended to be based on blue chip high quality stocks to be compared against small cap speculative stocks.
Myth: “…if the Industrials, Transports, S&P 500 and Global Dow all reach new highs (on increasing volume), then it’s a signal that good times are ahead…However, one interesting item to point out is the lack of volume on this most recent leg higher. Inside the black oval you can see that weekly volumes have actually been declining. This should temper our enthusiasm behind the push higher, but nonetheless the Industrials remain very bullish. ( Dow Theory Letters. December 9, 2016.).”
Fact: Since the bull market began in March of 2009, trading volume has been in a declining trend.
NLO Analysis: In the order of most concentrated index to most diverse index, we have drawn a black line to demonstrate the general trend of trading volume since the beginning of the bull market.
