It's been almost a hundred and twenty years since Charles Dow first created the Dow Jones Industrial average, commonly referred to as the Dow. Over that time the Dow has undergone a substantial transformation and now bears little resemblance to its prior form.
The Dow originally contained 12 industrial companies. Of those, the only company that remains part of the Dow is General Electric (GE). When initially formed, the Dow was truly an industrial index. All components in the Dow were intimately involved in traditional heavy industry, meaning they produced goods used in construction and manufacturing. Some examples include the American Cotton Oil Company, the American Sugar Company, the U.S. Leather Company and the United States Rubber Company.
During the 1920's the Dow was expanded to include 30 components, which has stayed the same to this day. The Dow also remains a price-weighted average, meaning each component's impact to the index is a function its stock price and not its market cap.
While initially comprised solely of industrial companies, the Dow's evolution has seen a drift towards many other sectors of the economy. In addition to traditional industrial companies, the Dow now contains financial companies such as JP Morgan Chase, Goldman Sachs and American Express, drug and healthcare companies such as Pfizer and United Health Group, technology companies such as Microsoft and Intel, and retailers such as Home Depot and Nike, among others. You've likely heard by now that Apple is set to join the Dow, replacing AT&T on March 18th.
The changing composition of both the Dow and the economy brings into question the efficacy of traditional Dow Theory. In its simplest form, Dow Theory is thought to forecast economic activity and thus the stock market because in a functioning economy, goods must be produced and they must be shipped. If either of these basic functions is inhibited, something is off and both the economy and stock market are likely to suffer.
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The revolution of the information age is changing this. While we are still consumers of tangible goods, a vast portion of our economy is now based on the creation and transportation of information. Take this article for example. It's production and consumption involve relatively few physical goods. Sure, I need a computer to type on and a few calories to power the hamster wheel in my head, and you need a computer to read this; but once we have those physical goods, the ongoing production (me writing) and consumption (you reading) can go on uninhibited. Heck, you don't even have to "transport" a check to us, you can enter your credit card details online. Dow Theory Letters is a perfect example of a company that produces and sells a product, contributes to GDP, but stands outside the production and shipping of physical goods.
So if the Dow is no longer representative of the "industrial" sector of our economy, and our economy is now slanted towards services and information, how relevant is it to look at the confirmation of averages and other such tenets set forth many years ago by Dow Theorists?
The answer, in my opinion of course, is twofold. Traditional Dow Theory is still relevant and it still works, but it is susceptible to flaws and should in no way be the sole focus of decision making regarding the outlook of equity prices or the economy.
The modern Dow Jones Industrial Index now represents not the industrial sector, but a subset of the largest and most influential companies in our modern economy. As a result, the prices of those stocks and the aggregate movement of the Dow are an important barometer. As you can see from the chart below, a traditional reading of Dow Theory would have provided indication that trouble was brewing before the major collapse during the financial crisis. Similar patterns and bearish confirmations can be found prior to nearly all significant sell-offs in recent history.
It's interesting to note however, that modern interpretations of "confirmation of the averages" such as looking at the S&P 500 and Russell 2000, provide much of the same advance warning. This begs the question, is it really that important to specifically look at the Dow and Transports or can we use other barometers of the overall market to the same avail?
Here's a good example of why the action in the Dow should be watched with a discerning eye. As a price-weighted average, a move in a high priced stock such as Goldman Sachs (~8 per share) impacts the Dow the same as a move in GE (~ per share), even though on a percentage basis those moves are incredibly different (0.53% vs. 4%). The result is that the value of the index is heavily driven by volatility in the highest priced stocks.
In a recent CNBC article, Eric Chemi made the case that based on the volatility and prices of the Dow components, once Apple is introduced into the index, approximately 26% of the Dow's daily price change will be a function of just Apple and Goldman Sachs. Should that be the case (the impact would be lower if the price or volatility of those two stocks declined), how much sense does it make to base market-wide investment decisions on the movement of the Dow in relation to the Transports?
For example, if the Apple Watch (debuted yesterday) turned out to be a bust and Apple shares tanked, or if Goldman Sachs found itself in more legal trouble and its shares plummeted, and this resulted in a "non-confirmation," how much emphasis should that carry?
The takeaway, for me at least, is that traditional Dow Theory should be an input into the decision making process, but not the driving factor. Enormous amounts of critical information can be gleaned from other market indexes, economic indicators, sector preferences, bond market behavior, central bank policy etc., that need to be factored in. It's a hybrid or fusion approach that works best in today's markets.
The following was an excerpt of Richard Russell's Dow Theory Letters. To receive their daily updates and research, click here to subscribe.
Related:
Christopher Quigley: What Dow Theory Says About the Stock Market
