With its roots in the nineteenth century, Dow Theory is among the oldest techniques in technical analysis. Some will argue that it has withstood the test of time and others will argue that it needs to be updated. Most debates in technical analysis will never be fully resolved to the satisfaction of everyone, but this one can at least be detailed and understood.
Charles Dow developed indexes to track the stock market action and the economy, and his first effort at this became the Dow Jones Transportation Average (DJTA). This average can be traced back to July 1884 and it originally included eleven transportation companies, nine of which were railroads. The original components of the DJTA were:
- Chicago, Milwaukee and St. Paul Railway
- Chicago and North Western Railway
- Delaware, Lackawanna and Western Railroad
- Lake Shore and Michigan Southern Railway
- Louisville and Nashville Railroad
- Missouri Pacific Railway
- New York Central Railroad
- Northern Pacific Railroad
- Pacific Mail Steamship Company
- Union Pacific Railway
- Western Union
Union Pacific remains a railroad and Western Union still exists as a company but in a more modern form. The Pacific Mail Steamship Company eventually grew to own more than 40 ships by 1920, and is today part of APL, which is a wholly owned subsidiary of Singapore-based Neptune Orient Lines, a global transportation and logistics company engaged in shipping and related businesses.
The other companies were merged out of existence or failed in some way. The current list of index components shows twenty companies with more familiar names:
- Alexander & Baldwin
- AMR
- C.H. Robinson Worldwide
- Con-Way
- CSX
- Delta Air Lines
- Expeditors International
- FedEx
- GATX
- JB Hunt Transport Services
- JetBlue Airways
- Kansas City Southern
- Landstar System
- Norfolk Southern
- Overseas Shipholding Group
- Ryder System
- Southwest Airlines
- UAL
- Union Pacific
- United Parcel Service
In the 1800s, railroads were the predominant form of transportation in the economy and it was easy to understand why Dow would think that they would offer a useful barometer of the level of economic activity. Now, it is sometimes argued, transportation stocks play a less important role in the economy. That may be true, but even in the days of the internet bubble, no one could argue that transports would cease to exist. A sock puppet would capture eyeballs and programmers would write software that allowed to Pets.com to sell dog food at insanely low prices, but UPS or FedEx were still involved in getting the product to the consumer. Those transport companies were also responsible for getting the hardware to run the web sites from the manufacturer to the vast server farms that were changing the world.
Over the long-term, the DJTA does seem to move up and down with the changes in the economy as Dow expected. The chart below shows that the average did move down during each recession over the past 35 years and the DJTA generally trended higher during economic upturns.
Dow Jones Transportation Average (DJTA)
(Click here to download full sized PDF)
Source: Securities Research Company
It is interesting to note that earnings and dividend growth have outperformed stock prices in the DJTA. That could be a sign that the stocks are undervalued by the investments community.
Growth Performance Measurement
Years Price Earn. Div. Total Ret.
Last 1 - 4.7 66.8 14.2 - 2.9
Last 5 - .6 - 1.7 13.2 .9
Last 10 7.0 18.6 8.7 8.2
Last 25 7.0 13.4 7.0 7.8
The Dow Jones Industrial Average (DJIA) dates back to 1896 when Dow included 12 companies in the original form of the index. Over time the companies in this index have also changed, but they have always represented a significant percentage of market capitalization. The index now includes 30 companies and generally represents about a third of the total US stock market capitalization.
A long-term chart of the DJIA shows a price pattern that is similar to the DJTA. This is again what Dow expected to see and the Dow Theory was developed without the benefit of hindsight. It is an impressive accomplishment that Dow could understand the relationship and the importance of confirmation and divergence without the aid of even a long-term chart.
Dow Jones Industrial Average (DJIA)
(Click here to download full sized PDF)
Source: Securities Research Company
In the 1990s, as the economy was undergoing permanent changes according to many observers, some thought the NASDAQ would be a better indicator of the economy than the older Dow averages. The idea of substituting the NASDAQ Composite index for the DJIA in Dow Theory interpretation was discussed by some analysts.
A long-term chart of the NASDAQ shows that it follows a similar general pattern, but it also shows what appears to be more volatility.
NASDAQ Composite Index
(Click here to download the full sized PDF.)
Source: Securities Research Company
Volatility is often confused with returns in an up market, which was most likely the case when the NASDAQ approached 5,000 in the first months of 2000. A study that was done comparing the performance of the DJIA to the NASDAQ Composite just before that time, however, disputes the idea that the total return of the two indexes was substantially different.
In “The Dow Jones Industrial Average: The Impact of Fixing Its Flaws” by John B. Shoven of Stanford University and NBER, and Clemens Sialm of Stanford University that was published in February 2000, it was shown that the indexes actually delivered similar gains when accounting for dividends. One conclusion the authors reached is that:
Our interpretation of these results is that the superior performance of the Nasdaq over the DJIA for the period 1973-98 is greatly diminished once dividends are considered. In fact, taking account of the noticeably higher monthly standard deviation in the Nasdaq Composite’s total returns, a case could be made that the Dow actually outperformed the Nasdaq over this time interval. This simply emphasizes the point that stock price indices are very poor measures of the total return to investors over lengthy periods of time.
Their work also highlights the fact that there is nothing wrong with using the DJIA for analysis. Having withstood the test of time, the Dow Theory remains an important tool for technicians in the twenty first century.
Michael Carr, CMT, has managed money professionally and is now an independent market analyst. His work is frequently published at several web sites and in magazines related to technical analysis. He is also the editor of the Market Technicians Association monthly newsletter, Technically Speaking.
