This spring, while the Dow Jones Industrial Average (DJIA) climbed to new all-time highs, the Dow Jones Transportation Average—a mix of airline, railroad, and delivery company stocks—noticeably slumped.
The venerable Dow Theory argues that such divergence has historically been a warning signal for the broader stock market. Should investors care? Yes, but only in context.
"We've been hearing a lot about Dow Theory. It basically says in order for a broader market advance to be confirmed, the transportation stocks also need to reach new highs," explained Sam Stovall, chief U.S. equity analyst at S&P Capital IQ.
If the broader stock market is rising, the implication is that the economy is improving and corporate profits are expanding. But when transportation stocks sit out a rally, confidence isn’t as solid as record highs might indicate. After all, transportation is an important piece of the economic pie.
"Since we have yet to create a Star Trek–like transporter, we still need planes, trains, and ships to transport raw materials or finished product to businesses or consumers," Stovall said.
S&P Capital IQ crunched the numbers and found that all stock market declines of 10% or more in the past 20 years have been accompanied by divergence between the DJIA and the transportation average.
But, significantly, "the reverse has not been true. Not all divergences have led to a [DJIA] decline of 10% or more," Stovall noted.
The Dow Theory divergence calls for investors to be on their guard, agrees JJ Kinahan, chief strategist at TD Ameritrade. But for now, the overall market itself is not flashing other warning signals, he countered.
Such red flags might include a sudden rally in bonds. Demand in bonds reflects investor interest in the perceived “safety” of fixed income because they think the economy will slow. Heightened investor nerves might also spark a rally in the CBOE Volatility Index (VIX) of more than 10% to 12% in a day. This is especially true of an outlier move for VIX independent of a similarly sized move in the underlying stock market, Kinahan said.
Nonetheless, "we are near all-time highs and you should use a little caution,” Kinahan said. “This may indicate there could be some weakness ahead. Be diligent. We have a lot of numbers and events in June, all with big potential to move the markets, including this Friday's May employment report, the upcoming European Central Bank interest rate meeting, and two Greek debt payments coming due.”
Adds Stovall: "Don't act [on the Dow Theory] in isolation. Use it in conjunction with other economic, earnings, and technical indicators when deciding when the next bear market is at hand.”
To analyze the gap on your own, TD Ameritrade charting functionality allows clients to overlay one market over another. Figure 1 shows the DJIA with an overlay of the Dow Jones Transportation Average.