Indicator of the Week: Debunking Dow Theory

Dow Theory used to be relevant, but less so in recent years

Senior Quantitative Analyst
Jun 10, 2015 at 7:15 AM
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With transportation stocks doing so poorly this year, Dow Theory is a hot topic right now. The basic idea is that transportation stocks are a good indicator for the market going forward. The logic behind it is pretty simple. If companies are doing well and shipping a lot of products, then the companies shipping the products should be doing well, too. When the shipping companies begin to fall, it means the rest of the economy could be close behind.

This week I'll take a quantified look at Dow Theory. Many of these well-known theories don't hold up when you actually quantify the numbers. We'll see if this is one of those things. 


Dow Rest-of-Year Returns: Here is what I did to test Dow Theory. For each year since 1975, I calculated the relative strength of the Dow Jones Transportation Average (DJT) to the Dow Jones Industrial Average (DJIA) from the beginning of the year to the first week of June. Then I found the return for the DJIA for the rest of the year. According to Dow Theory, when the relative strength is low -- meaning transportation stocks are underperforming -- the DJIA should have underperforming returns for the rest of the year. 

A summary of Dow returns for the rest of the year is below. According to these numbers, a low relative strength is a good sign for the DJIA going forward. When the relative strength was 0.96 or less, the index averaged a gain of 6.32% for the rest of the year and was positive 91% of the time. That average return and percent positive easily top the other two brackets.

The median return is lowest, though, for the low relative-strength column. This means the average is being skewed by an outlier return (in 1984, the DJIA gained 30% for the rest of the year). Still, 10 of 11 times, the DJIA moved higher in these cases, and the one down year was a modest 3.03% loss. The underperformance of transportation stocks has not been an ominous sign in the past.  


One thing people might note is that the economy is a lot different now than when Dow Theory came about. Manufacturing and shipping are a smaller chunk of the overall economy, so Dow Theory was probably more predictive in the past. Therefore, I did the same analysis as above, but instead of looking at data since 1975, I looked at the data from 1900 to 1975. The table below shows the summary of the results. 

Before 1975, the underperformance of transportation stocks did seem more worrying. The average return was only 2.52% when relative strength was lowest, which is the worst of the brackets. However, the median return was the highest. Those are the stats that are worrying.

The disquieting stats are the volatility figures. The standard deviation of returns was way higher for the rest of the year when transportation stocks underperformed, along with the average positive and average negative. That's what made transportation stocks so key. It's not that they foretold a collapse, but that they signaled a lot of volatility for the rest of the year. As you saw from the analysis above, that has not been the case in more recent times. In current times, Dow Theory seems to be getting a lot more press than it merits.



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