Is Dow Theory Dead?
Dow Theory is the oldest US market-timing theory. It was created
at the turn of the 20th century when Charles H. Dow and William
Peter Hamilton were fashioning a methodology for staying on the
right side of the long-term trend. In their simple wisdom they
surmised that if both the companies producing goods and moving them
to the markets were increasing in value, then the economy must be
doing well and thus the trend would remain higher.
To track this behavior they created the Dow Jones Industrial (INDEXDJX:.DJI) and Rail averages with the latter eventually becoming the Transportation Average (INDEXDJX:DJT). There were some rules added with the most important being the confirmation, or lack thereof, between the two averages. If one moved to new highs the other needed to confirm that behavior and do so within a reasonable period of time.
There are several Dow Theory newsletters still published, and though each can offer different interpretations about the market, they all take the original assumption for granted: that if the companies producing goods and moving them to markets are increasing in value, then the market will move higher. More importantly, another basic assumption is that the Dow Jones Industrial Average and the Transportation Average continue to reflect those two important parts of the economy -- but do they?
Although there is little to argue with in terms of the Transportation Index's composition, the Industrial Average is a different story. Less than a month ago, it underwent a significant shake-up that fundamentally altered it, making the financials the dominant sector. Have we really matured to the point where the financial sector can be considered our nation's primary product?
Although it is called the "industrial index," no longer are industrials the largest sector.
In fact, consumer discretionary isn't all that far behind the industrial sector at this point. The financial and discretionary sectors now account for 40% of the Dow Jones Industrial Index. Is that what Dow and Hamilton would have considered as requiring tracking some 100 years later?
When McGraw Hill ( MHFI ) teamed up with others to take the dominant stake in the DJIA, we probably should have seen this coming. More and more, the Dow is turning into a miniaturized version of the S&P 500 Index (INDEXSP:.INX).
To be fair, there clearly are some differences still, but the gaps are narrowing, not widening. Within a few years it will probably make sense to pull the name "Industrial" from the index since it clearly is a misnomer, but the value of the name will never allow that happen. Instead, it will morph into something totally different than what it began as, which poses the question: Is Dow Theory, as we know it, dead?