How Now, Dow Theory

Like Punxsutawney Phil, Dow Theory is an old-timey tradition lacking inherent predictive power. Source: Ron Ploucha/Getty Images.

Have you ever wished for a clear-cut market timing signal? Maybe a Punxsutawney Phil for stock markets? You aren’t alone. Even though no such signal exists, any time a purported technical indicator flashes, folks perk up. This time it’s DowTheory, which adherents say is on the verge of signaling a big bull. Sounds great! But like all technical indicators, Dow Theory is flawed—underpinned by fallacies galore—and not a reliable market predictor.

Dow Theory, born in the 1880s, claims trends in the Dow Jones Industrial Average (DJIA) and Dow Jones Transportation Average (DJTA) can tell you where all stocks will go. If both hit new highs together, the theory says you’ll get a strong bull market. If both dip below previous trailing lows, you’re in for a long ride down. (There is also a lot of mumbo jumbo in between, but we’ll spare you.) The former is what’s happening now: The DJTA hit a new high Tuesday, and the DJIA is still a tad below its all-time high. If it hits that point, it’s a confirmation for some investors that more bull market lies ahead. But if they both fall below their 60-day low, a bear market lurks.

It might seem a bit arbitrary to judge the market’s health based on two narrow categories, but in the 19^th century there was some fairly logical intuition behind it. During the late 1800s and early 1900s, industrials and shipping gauges represented a broad swath of the economy. If folks were confident producers and shippers would see more activity, they were confident demand was on the rise—bullish! But if investors lose faith in both at a similar clip, it means markets anticipate a big slowdown. To many, the spirit broadly rings true today—higher production plus more shipping means more goods moving through the economy, and markets, after all, are the ultimate leading indicator. Problem is, looking at industrials and transportation alone won’t accurately speak to the health of the entire US economy, which is predominantly service-based. Even with Tech, Financials, Health Care, Energy and Consumer companies making their way into the DJIA, with only 30 US companies (out of thousands in the US and globally), it just isn’t a valid reflection of the entire global (or even US) economy.

Plus, past performance doesn’t dictate future returns—a fallacy that cuts to the heart of Dow Theory. The DJIA and DJTA could both hit all-time highs right before a bear market. Or they could hit new lows while bottoming out, then start their march higher in a new bull. Whether or not two indexes have just moved in tandem tells you nothing about the future. If the Dow Theory truly worked, taken its most literal, it would imply outcomes that can’t match reality. We’d have a constant bull or bear market because the signals would always ... well ... signal. Constant new highs would push the bull market up, up, up and constant lows would breed more lows, pushing the bear lower. Ultimately it becomes a self-fulfilling prophecy.

Then, too, markets discount any widely known information—and textbook theories are quite widely discussed. To the extent Dow Theory has ever worked, it has been part of the canon for nearly 130 years. Markets know it inside and out. They are well aware of every Dow Theory acolyte’s expectations—and those expectations are baked into current pricing. Were it otherwise, and if Dow Theory actually worked, everyone would use it and everyone would always win. The abundance of false signals over time tells you this simply isn’t the case.

Simply, Dow Theory isn’t reality—and reality is what markets care about. Regardless of where the DJIA and DJTA go from here, the favorable economic and political backdrop, combined with investors’ still-low expectations, point to more bull ahead. Corporate profits and business investment are at all-time highs and rising as strong revenue growth allows firms to boost spending without drawing down cash buffers—an enviable, underappreciated position. Housing continues improving, with tight supply and rising prices driving more construction. And the shale boom has made energy cheap and abundant, giving households more flexibility, reducing businesses’ costs and driving efficiency gains. There are plenty of other reasons we think this bull market continues, too. But the fact two indexes just happen to hit new highs around the same time isn’t one of them.