Dow Theory is an older school of technical analysis in which one of the most important tenets is that transportation stocks – specifically the Dow Jones transportation average – are a leading indicator for the market as a whole. In recent months, despite numerous charges that Dow Theory is outdated, the transports index has proven once again that investors ignore these stocks at their peril.
The accompanying chart plots the performance of the Dow transports index against the S&P 500. In hindsight, transportation stocks provided a clear warning ahead of the tech bubble implosion, declining steadily from April, 1999, while the broader S&P 500 reached its peak 16 months later. The effectiveness of the Dow transports as a harbinger of doom before the financial crisis is a bit harder to argue. However, it's not difficult to compare the high volatility of transports seen between February, 1998, and April, 1999, to the period between May, 2007 and May, 2008, as evidence that transports did provide warning ahead of the financial crisis.
More recently, and importantly, the Dow transports index peaked in November of 2014 and dropped 18 per cent from there. The S&P 500's most recent peak followed six months later in May of 2015 (using monthly data). Is this just coincidence, or has the transport index predicted a mid-term top for the U.S. equity market yet again?
The historical success of the Dow transports index as a leading market indicator is based on the sector's high sensitivity to U.S. economic conditions. Railways, airlines and trucking stocks generally feel the pinch of a slowing economy before other sectors and, according to Dow Theory, act as the "canary in the coal mine" for all U.S. companies. It is likely not a coincidence that economist estimates for 2016 U.S. gross domestic product growth have been falling along with transportation stocks – from 2.8 per cent to the current 2.4 per cent.
Dow Theory is not universally respected. Stories such as CNBC's "Stop worrying about this ancient indicator" from June, 2013, underscore the existence of considerable investor skepticism.
Nonetheless, cautious investors looking to add to U.S. equity holdings should wait for stabilization in the transports index. Even if, as the skeptics argue, the sector doesn't effectively predict the future course of the entire equity market, it certainly does reflect the recent slowdown in U.S. manufacturing activity. Plus, in a wildly swinging market where even seasoned investors are struggling to gauge the market's next move, time-honoured rules of thumb such as Dow Theory are worth taking into account.
Follow Scott Barlow on Twitter @SBarlow_ROB.