After the last economic recession in 2008, where are we now? (Dow Theory)

It has been a good 7 years since we underwent the last economic recession due to the subprime mortgage crisis that led to the collapse of the United States housing bubble. This crisis has also led to the collapse and failure of some of the United State’s largest financial institutions and banks  such as Freddie Mac, Lehman Brothers, AIG and Citibank.

The Dow Jones Industrial Average (Dow) reached it lowest point in March 2009 at 6,500 over points, and it has recovered to a peak of 18,300 over points; historical all time high level (in May 2015) since then. At this junction, have you wondered where are we in the market cycle right now?

I have been a great follower of Charles H. Dow’s concept of ‘Dow Theory’ that was derived over 100 years ago. The ‘Dow Theory’ is a belief that the stock market as whole is a reliable measure of overall business conditions within the economy. By analyzing the overall market, one could accurately gauge those conditions and identify the direction of major market trends. It is a form of technical analysis that includes some aspects of sector rotation.

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Mr Charles H.Dow

Dow first used his theory to create the Dow Jones Industrial Index and Dow Jones Rail Index (now known as Dow Jones Transportation Average). The indices were created because he felt they were an accurate reflection of the business conditions within the economy because they covered two major economic segments; Industrial and Transportation.

In Dow’s opinion, a bull market in Industrial (Dow Jones Industrial) could not occur unless the railway average (Dow Jones Transportation) rallied as well. According to his logic, if manufacturers’ profits are rising, it follows that they are producing more. And by producing more, they have to ship more goods to consumer (and the same applies for commodities companies to ship resources to industrials for production).

Hence, if an investor is looking for signs of health in manufacturers, he or she should look at the performance of the companies that ships the output of them to the market. The two index should be moving in the same direction. When the performance of the averages diverge, it is a warning that change is in the air.

I have been observing both Dow Jones Industrial and Dow Jones Transportation for the past 5 years and both averages usually move in the same direction, almost like an mirror image. Nothing has fancied my attention to this theory.

Until today.

2015Jun-Dow Jones Averages Industrial Average-800x600 2015Jun-Dow Jones Averages Transportation Average-800x600

 

There is no doubt that today’s economy is much different and the makeup of the DJTA has changed to favor the airlines. However, there is still some credibility in using the DJTA to confirm movements in the DJIA. Transport stocks are much more dependent on the economic environment than the average stock and will likely foreshadow economic growth.

  • The airline business is cyclical and revenues are highly susceptible to economic changes.
  • Airline companies typically carry above average levels of debt and will be more vulnerable to changes in interest rates.
  • Energy and Labor costs form a large portion of expenses.

Conclusions

Dow theory helps investors identify facts, not make assumptions or forecast. It can be dangerous when investors and traders begin to assume. Predicting the market is a impossible task. While Dow theory may be able to form the foundation for analysis, it is meant as a starting point for investors and traders to develop analysis guidelines that they are comfortable with and understand.

 

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