How Predictive Is Dow Theory?

Does the Dow Jones Transportation Average (DJTA) know something broader markets don’t? If you have paid attention to some pundits’ claims, you might think it holds special magic, foretelling future broad market moves. But as we have written, there is nothing special about transport-based gauges. Stocks are stocks, and none are smarter than another set.

The DJTA consists of 20 stocks and, like its more famous 30-stock sibling, the Dow Jones Industrial Average (DJIA), is price-weighted. That alone should give you pause, never mind its narrow sliver of the broader stock market. Price weighting means a member’s share price determines its weight in the index. But this is arbitrary. In a price-weighted index, stock ABC worth $100 with only 2 shares outstanding would have 10 times the influence of $10 stock XYZ with 200 shares outstanding, even though the latter’s market cap is 10 times bigger. Weighting stocks by alphabetical order makes about as much sense. The only good (historical) reason to price weight is easier calculation, but with the advent of computers, that ship sailed long ago. Still, Dow Averages’ quirky legacy carries on.

The same goes for transportation’s market relevance. Early in the Industrial Age, when railroad tycoons strode the earth, its economic might wasn’t questioned. Transportation (and logistical) infrastructure is still important today—food and energy are, too; some of our favorite things! But as a percentage of the MSCI World Index’s market cap, for example, Transportation is 2%—there are much more economically important sectors nowadays.^[i] Despite the Dow Transports’ aura of historical importance, it is a mistake to overrate it, much less the alleged signals it sends about the economy and stocks generally.

Two weeks ago, pundits proclaimed the DJTA’s outperformance for the year at that point was an all-clear signal. Year to date through March 29, the DJTA was up 1.5%, beating DJIA’s -2.9% and S&P 500’s -2.8%.^[ii] Supposedly, this was “a sign of optimism about the economy’s strength that could fuel a broader market rally.”^[iii] Now, we fully agree the US economy is in much better health than most appreciate and on firm footing. As that dawns on investors, the positive surprise should be a relief that extends the bull market further. But Transportation stocks weren’t a good indication of that.

Consider: Since March 29, the DJTA has plunged -13.1%.^[iv] Some pundits warn its falling over -20% from its November 2 intraday peak is a recession signal.^[v] For context, we should note that the DJTA was extremely volatile on November 2 owing to wild, speculative trading around one of its components, a rental car company, which happened to catch the fancy of the “meme stock” trading horde that day. Making any broad conclusion from an anomalous one-off gyration seems exceedingly tenuous to us. Nevertheless, those treating the DJTA as a bellwether now argue the gauge’s drop is bearish for broader markets—where Transports go, they argue, Industrials and other sectors will follow.

History disagrees with this notion, though. Exhibit 1 shows the DJTA’s spotty record of flagging recessions. Using daily data, DJTA declines of -20% from prior peaks haven’t proven very predictive. Being generous, it has called 14 of the last 6 recessions. Only two look well-timed. Others, like December 2018’s, came much too far in advance of a recession. COVID and the lockdowns that drove 2020’s recession were over a year away.

Exhibit 1: DJTA’s Poor Recession-Calling Record

Source: FactSet, as of 4/12/2022. DJTA, 12/31/1977 – 4/11/2022.

Likewise for bear markets, the DJTA has called two of the last six beforehand. (Exhibit 2) There have been many more false (eight) and late (four) warnings than timely ones.

Exhibit 2: DJTA’s Poor Bear Market-Calling Record

Source: FactSet, as of 4/12/2022. DJTA, 12/31/1977 – 4/11/2022.

To be clear, the stock market is a good leading economic indicator, in our view. Our issue here is that a narrow and poorly constructed gauge like the DJTA is, contrary to recent theories, less useful than a broad one. At best, the DJTA may give some indication of how the transport sector is faring, but that is about it. The US economy is far more services-based today, with increasing shares of it conducted electronically, for the DJTA to reflect America’s economic outlook as a whole.

More importantly for investors, though, stocks can’t say anything about stocks. One segment of the market doesn’t have any more privileged knowledge or foresight than another. Markets price in all widely available information simultaneously—different sectors and stocks just react differently to it. Ultimately, whatever the gauge, the key thing to remember is that past performance never predicts. Taking one group of stocks out of context and shrouding it with unearned importance doesn’t change that.