There are a lot of different ways you can look at the financial markets. Proponents of fundamental analysis like Peter Lynch liked to simplify things as much as possible and would recommend paying attention to companies that make the products or provide the services you use on a regular basis. Others prefer to take a value-oriented approach, following the lead of famous investors like Benjamin Graham and Warren Buffett by looking for stocks that are currently trading at major discounts with a strong case to make for higher prices. Short-term investors and traders like to use the analysis of trends, swings and pivots to identify ways to take advantage of relatively short-term swings from high to low.
One of the theories that has persisted the most over the last hundred years was first presented by Charles Dow, the founder of the Wall Street Journal and Dow Jones & Company (and the same man that developed the famous Dow Jones Industrial Average we use to gauge broad market movements today). It’s called Dow Theory, and while there are multiple aspects of the theory that could each merit a long and detailed analysis on their own, there is one that I want to focus on today.
Indices must confirm each other
In order to establish or confirm a trend, Mr. Dow theorized that different market indices must provide confirmation of each other. The theory follows the logic that the different industries that make up the economy are interconnected, requiring mutual relationships that benefit each other. Thus, if an index that tracks one industry or sector is rising, it should follow that the industries and sectors that provide support in one form or other to that first industry should also rise. Healthy business conditions in one industry should naturally translate to healthy conditions in those industries on which it depends.
When Dow first formulated his theory, the United States was a growing industrial power in the world, with factories scattered throughout the country. The goods these factories created had to be transported over great distances within the country, and so they relied primarily on railroads. This is why one of the most common examples of how this rule works comes from the relationship between industrial companies and railroads. If an industrial company, such as Caterpillar, Inc. (CAT) is driving to new highs, or breaking above significant prior highs, it should follow that the businesses that transport Caterpillar’s heavy machinery to the market should also be showing strength. As of this writing, CAT has increased in value by more than 14% over the last month; it should follow, then that the stocks that help support CAT’s business should also be showing strength. Let’s take a look at CSX Corp (CSX), one of the largest railroad companies in the U.S.
Since finding a low point in the first week of April around $54.50, CSX has rebounded more than 18% to its current price at nearly $65 per share. This suggests that, indeed, these different, but complementary sectors are supporting each other. What if we take a queue from Charles Dow and draw our analysis out to a larger macroeconomic level using a couple of his major market indices, the Dow Jones Industrial Average and the Dow Jones Transportation Average over approximately the same period?
- Dow Jones Industrial Average: + 4.1% since the beginning of May
- Dow Jones Transportation Average: + 6.2% since the beginning of May
Even as the market has struggled over the past week to drive to new highs amidst uncertainty about a variety of geopolitical factors, it is interesting that over the last three weeks both Industrials and Transports have shown significant strength. These are complementary, supporting moves that most economists would be forced to concede are indicative of a healthy overall business environment.
It’s true that the market is always subject to change, and the generally favorable conditions that exist today could easily shift in the opposite direction over the next several weeks. The threat of tariffs imposed by the U.S. on steel and aluminum remains a looming concern, and this week the Trump administration added fuel to that fire by indicating new tariffs on auto imports could be next. That is a good example of something that could have an extended ripple effect throughout the economy over a longer period of time, and so any smart investor should be conscious of the downside risks of any new positions they take on; but that also should preclude you from taking advantage of good opportunities as you find them.