Dow theory

The age-old Dow Theory gets a mention in the latest issue of Grant's. According to Grant's it is the only reliable way of measuring US economic growth. (Grant's argues that as traditional methods of measuring economic growth don't seem to be influencing Federal Reserve policy decisions, perhaps due to concerns about the data, Dow Theory is a more reliable indicator.)

According to the Theory, when the Dow Industrial and Dow Transportation index move in lockstep, economic strength is showing through. However, when the two indexes move apart, the implications are concerning. Year to date, the DJTA is lagging its industrial peer by 6.3%. What's more, while the DJIA sits only 1.5% below its all-time high printed earlier this year, the DJTA is around 11% below its all-time high reached at the end of last year. It's not just enough to monitor the two indexes on a daily or even monthly basis.

Movement or divergence must be observed over a lengthy period. As the logic follows, if there is to be a valid increase in consumption, manufacturing and production, there will also be an accompanying increase in shipping and transportation. There's a case of extreme divergence between the two indexes. The DJTA is, in fact, breaking down at six-month lows -- one of the widest divergences in Dow Theory's history.

Dow Theory: Still Relevant?

Grant's goes on to discuss the relevance of Dow Theory in today's market. During 1999, when the DJIA reached a new high, will the DJTA lagged, few were concerned. The world was changing, and there was no longer a need for industrial companies. The world economy was being driven by asset light, cash generative tech companies. A bear market followed six months later. The same scenario took place during 2007. In this case, the DJTA moved to a new high, which wasn't confirmed by the DJIA.

Still, when Dow Theory was initially conceived (before the 1913 Federal Reserve Act), few ever thought that the Fed would embark on a money printing binge that has sustained a rally the likes of which the market has only ever seen twice since 1929 (1990 to 1997 and 2003 and 2007).

Concerning data

The divergence between the DJIA and DJTA highlights underlying economic trends. A June 3 report from the Association of American Railroads showed that during the first quarter, total rail volumes across the US fell by 0.6% year on year during the first quarter. During May, BAML analysts noted that their truck shipment survey fell to 60.7, a year-on-year decline of 11%, the ninth consecutive year-on-year decline.

Other data also supports the fact that the index divergence could be a sign that a correction is just around the corner. For example, M&A activity hit a new all-time highlast month, the same happened during 2000 and 2007. Merger wars often lead to a decline in equity prices soon after the peak.

Only time will tell if all of these indicators are indeed warning of an imminent crash.