Wall St. is full of theories attempting to explain price movement after the fact or predict price movement before it happens. The Dow Theory is one such theory, but for reasons discussed below, I believe the theory's relevance is long past, and in today's form, is utter garbage.
Generally speaking, the Dow Theory attempts to gauge the health of the economy using the movement of the Dow Industrials and the Dow Transports. More specifically it states the movement of the Industrials and the Transports must confirm each other or a trend change is likely to take place.
The Industrials make products; the Transports ship products. If the Industrials make a new high but the Transports do not, it's a sign companies are making products but not shipping them - not good. If the Transports makes a new high but the Industrials does not, it's a sign products are being shipped, but companies are cutting back on production - also not good. The theory makes sense - that the movement of one must confirm the other or else the divergence signals a reversal - but it also makes many assumptions. And it's these incorrect assumptions that render the theory nothing more than something technical analysts and newsletter writers use to sell "stuff" to the public.
Here are my reasons the Dow Theory is useless today.
1) The Dow Jones Industrial Average is not an industrial average
The first Dow Index was comprised of industrial companies that made physical products, so the movement of the average was a pretty good indicator of products being produced. But this isn't the case today because many Dow components don't make anything.
JP Morgan, Bank of America, American Express, AT&T, Verizon, Travelers, UnitedHealth Group - these companies do billions of dollars of business every year without making or shipping a single product. Even IBM is mostly a services company, and although Microsoft can put their software on CDs and ship them, this isn't how the bulk of their revenue is generated.
So, the Dow isn't an industrial average anymore because many companies make billions of dollars without relying on the transports for shipping. Right here, the link between the two indexes breaks down.
If the Dow Theory assumes industrial companies make products and the transports ship them, the entire theory breaks down when non industrial companies were added to the Dow.
2) The Dow Industrials and Dow Transports are price weighted.
The theory assumes the prices quoted at the end of every day are an accurate reflection of the stocks that comprise each index, but because of the way the indexes are calculated, an argument can be made this isn't the case.
Price-weighting means the influence a stock has on the movement of the parent index is directly proportional to the stock's price, i.e. higher-priced stocks have a greater influence on the index's movement than lower-priced stocks.
This means Chevron (CVX) has greater influence than ExxonMobil (XOM) even though XOM is almost twice as big.
General Electric (GE) is the fifth largest Dow stock but because it's the sixth cheapest, its influence is underweighted. Microsoft (MSFT) is four times bigger than Caterpillar (CAT), but since CAT is three-and-a-half times more expensive, it's much more influential.
UPS (UPS) is twice as big as FedEx (FDX), but since FDX is more expensive, it exerts a greater force on the parent index.
Even if the Dow Industrials only contained industrial companies, it can be argued that permitting the smaller stocks to "do more of the talking" results in an index that isn't a true reflection of the economy's health.
Because the indexes are price-weighted and do not consider market cap or other variables, they are calculated such that the results aren't a true reflection of "what's going on."
3) The theory does not consider volume.
Volume in the market equates to votes. The more volume, the more traders/investors are in favor of the price move. Basic technical analysis says volume must confirm a move, but the Dow Theory, as it's interpreted today, makes no mention of volume.
At the time of this writing, JP Morgan (JPM) and DuPont (DD) were trading at the approx. the same level; so generally speaking, they have the same influence on the Industrials. This means, on any given day, if DD is up 20 cents and JPM is down 20 cents, the net effect would be a wash because the movement of the two stocks would cancel each other out. But shouldn't one consider the fact that JPM trades 23 million shares/day while DD trades only 6 million?
At $45, $1.04 billion worth of JPM stock will change hands but only $270 million will change hands with DD. Equal and opposite movements of each stock should not cancel each other out. JPM should have more influence because more "money" is traded, but that's not the case.
Because the calculations of the indexes do not consider volume or the amount of dollars that change hands, the movement of the Averages is not a true assessment of the "voting" that is taking place.
4) Inefficiencies in shipping blur the purity of the theory.
The original Dow Transports were all railroads which transported massive quantities of goods. This resulted in a fairly fixed and low per-unit shipping charge. If the transports were bid up, very likely more products were being shipped. But this isn't the case today because the per-unit shipping charge has increased dramatically due to our inefficient shipping methods.
Instead of having a truckload of widgets shipped to a store (at a cost of $0.25 each), an individual widget can now be shipped directly to your mailbox for $5. This works to increase the profits for the transports, which is then reflected in higher stock prices for the transports, but isn't necessarily indicative of increased business for the producers.
And what about the resale of products? A single item may be shipped several times; a $25 book may accrue $20 in shipping charges over time. Rallying transport stocks are supposed to suggest economic growth via the shipping of products, but this isn't the case when the same item is inefficiently shipped over and over.
The inefficient manner in which products are shipped messes up the purity of the theory. A strong transports group isn't necessarily a sign of business expansion.
5) Wal-Mart ships its own products.
Wal-Mart is the largest retail store in the world, so if business is going well, it will be reflected in the Transports Average because, after all, many boats, trucks and trains are used to get their products to market, right?
Wal-Mart ships most of its own goods. They have more than 5,600 tractor trailers, 6,900 truck drivers and 60 distribution centers in 28 US states. But even though Wal-Mart is technically one of the world's largest shipping companies, it's not a component of the Dow Transports.
Is the Dow Transports a true reflection of the movement of products if the largest retail store in the world can ship hundreds of billions of dollars worth of goods but not have this movement reflected in the Transports Average?
The Dow Transports is not a good reflection of the movement of products because it doesn't take into consideration the movement of products flowing through Wal-Mart.
6) The theory does not take into consideration stock splits.
This is related to item #2 above. Since the indexes are price-weighed, the exact time a stock splits will greatly influence whether an index makes a new high or low. Doing a 2-for-1 or 3-for-1 stock split doesn't change anything about a company. The company is still valued the same; the dividend yield is the same; earnings per share is still the same; business has not increased or decreased. There is no material change in the company other than the stock price. But the company then has much less influence on the movement of its parent index, and if the split takes place at exactly the "wrong time," it could influence whether the parent index makes a higher high or lower low.
Stocks splits are a marketing tool companies use to tinker with their stock prices. The fact that this activity actually influences the movement of the indexes has to make you wonder if accurate readings of the indexes are possible.
There are other reasons such as the fact that the transports often make money via fuel surcharges, so a rallying stock is not a guarantee the underlying company is shipping more products.
Wal-Mart can ship billions of dollars in products and have no influence on the movement of the Transports. Massive companies like Microsoft have much less influence than much smaller companies like DuPont. Heck, the theory breaks down right at the beginning when one realizes the Dow Industrials isn't even an industrial average, and it breaks down even further when one considers how the indexes are calculated in the first place.
Sorry, the Dow Theory doesn't work on paper for the reasons explained above, and it doesn't work in practice (beyond the scope of this write-up).
Just as many of the economic numbers released by the government were invented solely so analysts could write reports and sell "stuff" and promote "things" to the public, the Dow Theory is nothing more than something for technical analysts and newsletter writers to talk about so they can sell more "stuff" because if you actually think about it, the Dow Theory is of little use today.
[Editor's note: What do you think about this long revered theory? Is it still valid? Some say a buy signal was generated recently. Read the MarketWatch story here and let us know what you think below!]
= = =
New Markets Story: