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The Dow Jones Transportation Average ($TRAN) closed at a new all-time high on Tuesday. To some market watchers, the strength in transportation sector is a positive sign for the economy and the stock market. It indicates that, despite the recent spike in energy prices, transportation companies are doing well. Profits and share prices are moving higher. However, according to Dow Theory, the recent high in the transportation average is not bullish because it has not been accompanied by new highs in the Dow Jones Industrial Average ($INDU).

Dow Theory is one of the oldest forms of market analysis. Based on the early work of Charles Dow, the originator of both the transportation and the industrial averages, the theory is a form of technical analysis that addresses both price action and fundamentals. The theory has many tenets. One tenet is that the market averages discount everything. That is, stock prices as a whole reflect all available information. Prices reflect the total of interest rate movements, earnings, geopolitical events, and any other significant market event. In other words, the things that are known, and even some of the things that will happen in the future, are already factored into stock prices and therefore also priced into the market averages.

Another tenet of Dow Theory is that the two main averages—the industrials and transports—must confirm one other. Charles Dow developed both the Dow Jones Industrial Average and the Dow Jones Transportation Average in the late 19^th century. When it was created in 1884, the transport index was known as the Dow Jones Railroad Average and was computed as the average closing price of nine railroad companies.  The index was computed daily and published in a financial publication known as the Customer’s Afternoon Letter (a predecessor to today’s The Wall Street Journal).   Through the years, airline, air transport, and trucking companies have been added to the index.  It includes twenty companies and is known as the Dow Jones Transportation Average.  

The more widely watched Dow Jones Industrial Average was created after the railroad average.  In 1896, the original industrial average included just twelve companies.  These were large smokestack companies that were considered the leaders of the late 1800s.  Since that time, the list has expanded to include thirty stocks and General Electric (GE) is the only original member that still remains part of the industrial average today. In addition, the “industrial” average also includes many non-industrial stocks like financials, healthcare, and consumer product companies.

Despite the changes in the averages over the years, Dow Theorists maintain that the transportation and industrial averages must move to new highs or new lows together in order for the main trend to have staying power. This is one of the tenets of Dow Theory. According to Dow Jones & Co.,

If the industrials reach a new high, the transports would need to reach a new high to ‘confirm’ the broad trend. The trend reverses when both averages experience sharp downturns at around the same time. If they diverge for example, if the industrial average keeps climbing while the transports decline watch out!…The underlying fundamentals of the theory hold that the industrials make and the transports take. If the transports aren't taking what the industrials are making, it portends economic weakness and market problems, Dow Theorists maintain.

Why does Dow Theory maintain that the two averages move together? At the turn of the century, railroads were the main industry of the day. Before economic activity could begin to expand, raw materials and supplies had to be shipped to manufacturing companies. This increase in activity in the railroad companies would lead to activity in that the sector of the stock market and signal that a boom had begun. If the signal was legitimate, then the industrials would follow soon after. In short, one average must soon follow the other during an upturn. Similarly, if one average fails to confirm the other during an advance, it could serve as an early warning signal that the trend is set to reverse. It doesn’t matter which average is heading to new highs and which one is not. They both must move together.

Figure 1: Industrials and Transports

On Tuesday, however, the transportation average rose to new highs, but the Dow Jones Industrial Average did not. Figure 1 shows the recent action of the two averages. As the transports have rallied to new highs, the industrials remain 2.5% below their recent highs and well below the all-time peak set in the year 2000. According to Dow Theory, the industrials will have to catch up to the transports soon or, since the two averages are not confirming each other, the recent bullish market trend is likely to reach a very nasty end.

Importantly, Dow Theory is interesting, buy probably not a reason to head for the hills yet.  After all, the theory was developed based on the tenets of Charles Dow—an astute investor without a doubt, but one who did his work more than a century ago. During Dow’s era, industrial and transportation companies were the dominant companies.  Today, that is no longer the case. Technology, financials, healthcare, and energy stocks are also important components of the market. Therefore, if the transports and the industrials continue to move in opposite directions, it will urge caution. However, for now, it makes more sense to wait to see if the industrials start to play catch up the world’s oldest market average.


Frederic Ruffy
Senior Writer & Index Strategist
Optionetics.com ~ Your Options Education Site
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