Dow Theory

Most of traders and investor would know Dow Jones Industrial Average (INDU) is a price weighted index of 30 US blue chip companies.  It is the second oldest US stock index behind 124-year old Dow Transportation Average (TRAN) which is also price weighted and represents 20 large US companies within transportation industry. 

There was a major change in the components of INDU on 31 Aug when Amgen (AMGN), Salesforce (CRM) and Honeywell (HON) replaced the well known companies – Exxon Mobil (XOM), Pfizer (PFE) and Raytheon (RTX) as Apple (AAPL)’s 4-1 stock split would reduce the weight on Information Technology sector that was already under-representing compared to other major market cap weighted indexes. 

 The update removed XOM, the longest serving member of the index that was once world’s biggest company back in 2011 however, the change is yet to have any significant impact on the YTD return as INDU’s negative performance still clearly lags behind both S&P 500 (+6%) and NASDAQ (+27%).  Interestingly TRAN so far has outperformed INDU in terms of year to date performance, 7% vs -1%.  The top two outperforming stocks within TRAN have been FedEx Corp (FDX) and United Parcel Service (UPS) which both gained 77% and 49% YTD respectively.  The worst stocks are unsurprisingly the airline stocks including United Airlines (UAL) and American Airlines (AAL) with -59% and -54%.  Fortunately, TRAN has a lot less weightings on these lagging airlines so there has been insignificant drag on the return of the index.

Since coronavirus, NASDAQ index has rapidly grown in both interest and market cap this year but these two out of favor indexes (INDU and TRAN) can still provide some useful insights on the market conditions by Dow Theory which has been around for more than a century.  It is essentially a belief that studying the two can indicate a basic market trends when both averages break previous swing high or low levels.  It may sound like a technical analysis, however the logical idea behind this signal could be more than just another indicator in current conditions as business activities and earnings are more sensitive to shipping and logistics triggered by lockdowns and change in the way people live post coronavirus.

Today TRAN gained 80% from March 2020 sell off low and hit all time high 11,737 surpassing the previous peak 11,623 that was printed back in Sep 2018.  In the meantime, the record high of INDU was 29,568 on Feb 2020 but the index has not yet either retest or break that level yet.  The obvious reasons behind this underperformance may be explained by the lack of tech components despite the inclusion of Salesforce and also Apple now having only less than 3% weight rather than pre index change weight of 12%.

Unless we see INDU to push itself higher above 29,568, it may be premature to validate or confirm a bullish outlook and relatively it is not expected to be an easy task as its components are largely less growth stocks with the index PE ration of 24 compared to NASDAQ’s 66.  This is even despite the fact that IT sector has the largest weight of nearly quarter of the index as only Apple is the sole stock out of the FAANG stocks hence it is missing out on the other trillion market cap tech stock’s momentum that has shown strong growth anticipation over the last six month.  Since Road/rail and freight/logistics sectors take up to nearly 90% of the TRAN, the recent outperformance over INDU may continue to exist even though we still see uncertainties surrounding impacts of the coronavirus.

It is easy to just follow and trade FAANG stocks or growth driven tech sectors related to cloud, chips, data and battery or even iron ore and soybean futures that are enjoying and maintaining strength with backwardation in their term structure, however the Dow Theory between INDU and TRAN may still provide relevant analysis to convince either speculators or investors who questions the magnitude of the recent recovery of stock market and those asking how long this current bull run can sustain its valuations heading into US presidential election in less than 4 weeks.

Dow Industrial Average can be traded by number of instruments: US30 (CFD), YMZ0 (futures), YM (futures options), DJX (index options), DIA (ETF)

Dow Transportation Average can be traded on IYT which is iShares ETF that has risk rating of 2.