All trout are fish, but not all fish are trout. College students learned this in Logic 101. But does the same hold true with investing? Dow Theory says that when the Dow Jones Transports (DJT) diverge from the Dow Jones Industrial Average (DJIA), the broader market is vulnerable to a meaningful price decline. So far this year, the DJT has significantly underperformed the DJIA. To many Dow Theorists, that is a bad omen. But when monitoring the rolling 13 week relative strength of the DJT vs. the DJIA over the past 20 years, while stock market declines of 10% or more were typically accompanied by divergences in excess of one standard deviation from the mean, not all divergences of that magnitude resulted in declines in excess of 10%.
Charles Dow may have intended the Dow Theory to be a soft, time-flexible warning signal of economic disagreement, rather than a hard and fast, time-specific, rules-based investment approach. Besides, most indicators are not meant to be used in isolation, but rather as a confirmation of other indicators. Therefore, while the sharp divergence of performances between the Dow and its Transports since the beginning of the year may sound alarm bells to some, it represents dissonant noise to others. We believe this divergence has issued a yellow alert for the stock market and should not be ignored. Indeed, it recently helped S&P Capital IQ’s Investment Policy Committee decide to lower the recommended exposure to U.S. equities, and increase the cash allocation. However, the divergence is probably best used in conjunction with other fundamental and technical indicators before signaling a red alert, or that a new bear market is just around the corner.