Thursday, September 27, 2012

Do the Transports still matter under Dow Theory?



 Should other indices be included?


What indices should be taken into account in order to apply Dow Theory? This is a thorny issue where disagreement reigns among the Dow Theorist fraternity. I hope this blog helps little by little to set the record straight. This post is a small contribution to this noble end.

Some say we must stick to the Transports and Industrials in the same way Charles Dow did 112 years ago, being any variation pure heresy.

Others say that the Transports are dated and lack any predictive power and hence should be discarded.

Others say that the Transports are still OK provided they are supplemented by new indices that didn’t exist 112 years ago. Some say that the S&P is to be included to the mix, others say that the Nasdaq. Some even say that the Utilities might make a better addition.

Finally, one Dow Theorist even went as far as to claim that the principle of confirmation might be safely ignored in many instances and hence just the action of the Industrials mattered and its 200 day moving average.

So, who’s right? What should we do as investors?

Well. To give you an answer first of all we have to know what our timeframe is. Are we Dow Theorists of the secular Schaefer “flavor”, hence riding the secular trend that may last more than 10 years? Are we Dow Theorists of the Rhea/Schannep flavor more interested in investing along primary bull and bear markets (whose median duration is 2.5 years)? Or are we mere traders interested in trading secondary corrections (duration 2 weeks-8 months)?

If this talk about “flavors” sounds queer to you, maybe you should read the following posts in order to know the different “families” or “breeds” of Dow Theorists. Under the name “Dow Theory” many investment styles cohabit. More information here, here and here
   
As I have just written, Dow Theorist Schaefer even suggested that the principle of confirmation (that is for a Dow Theory signal to be valid it is necessary that two indices confirm) was dated and superfluous in many instances. Was he insane? No he wasn’t. Being a “secular” trend investor, his main focus was values. When your investment horizon extends beyond 10 years technical issues pale and the fundamentals, value, come to the fore. Being concerned with appraising value and positioning himself along a very long term trend, the principle of confirmation seemed a little bit superfluous. And he may be right in his timeframe.

However, most investors’ timeframe is of the Rhea/Schannep/Russell (depending on circumstances) “flavor”. For such investors the main focus is to invest along primary bull markets which have a median duration of 2.5 years. Hence, such investors, in spite of being quite long term oriented, are not in Schaefer’s “secular” league. Curiously enough when your timeframe is reduced to a median of 2.5 years, technical aspects begin to be as important as value considerations and, thus, the principle of confirmation still holds true. In other words: Dow Theory’s theorem that the movement of one index unconfirmed by the other tends to be deceptive and doesn’t constitute a Dow Theory signal is still as valid today and it was 112 years ago, provided we know our timeframe.

But here come the thorny issues that tends to divide Dow Theorists. Are the Transports to be considered? Should one stick to just the two indices mentioned by Charles Dow 112 years ago? Should new indices be added to the mix?

The Transports have always been the main culprit. Already in 1960 Schaefer was hinting that the Transports needed an “update” and include not only “rails” but other transportation companies such as airlines. This update was carried out in the ninety seventies.

However, in spite of its now varied composition which includes all transportation sectors and not merely “rails”, the Transports still bear the stigma of not including leading companies and not being “tuned” to the broad market. The Transports are accused of not being a “growth” sector, thus not being representative of the real condition of the market.

Should we then get rid of the Transports? No, we shouldn’t. Leading Dow Theorists Russell and Schannep are in agreement as to keeping the Transports as a relevant index of the Dow Theory. Why? Because Charles Dow’s main idea, namely, that the Transports should fare well if the producers are faring well, still holds true. If the economy is roaring merchandises are supposed to be shipped. And such shipments will increase the bottom line of transportation companies. So the basic concept remains as valid today as it was yesterday. The Industrials (or S&P) and the Transports cannot diverge in the long term.

A common criticism against the Transports runs as follow: The Transports are not a growth segment of the economy anymore, so it is impossible for them to track or increase by a similar amount than the Industrials or the S&P. Furthermore, they say, the Industrials or the S&P have gained much more percentagewise than the lagging Transports. Such blatant underperformance results in an ineffective index in order to provide the much needed confirmations under Dow Theory.

While appealing on the surface, such argument reflects a poor understanding of the Dow Theory. For one index to confirm new highs or new lows made by other indices, it is not necessary that the confirming index increases or decreases by a similar amount percentagewise. Only the direction of the movement matters. In other words, if the Industrials make new highs after a 10% rally, it is not necessary for the Transports to rally 10% as well. A confirmation will be flashed provided that the underperforming Transports make new highs (even though such new highs represent a “mere” 6% rally). This explanation is at odds with a basic misunderstanding of the Dow Theory when, misguidedly, it is stressed that, i.e., “the June 2011 highs have to be bettered in order to confirm the bull signal of the Industrials”. Monthly highs (or lows) are not carved in stone. What really matters is that (for a bull signal) following a primary bear market swing (leg) a secondary reaction follows, thereafter a pullback and finally a rally that breaks through the secondary reaction highs. The relevant highs to be broken are the latest secondary reaction highs, even though such highs may be significantly lower that the “highest” highs hitherto made. In other words, the “relevant” highs (lows) to be bettered (or broken) are self-adjusting with market action. Relevant secondary reaction highs (lows) that were not broken, cease to be representative when after a new primary swing down (up) follows a new secondary reaction, a pullback and a new rally.

An image is worth more than 1000 words, go to this post and look at the chart of the Transports and my comments thereto.

You will see two blue rectangles that highlight two secondary reactions and a red rectangle that highlights the primary bear swing. The high made by the first secondary reaction against the primary bearish trend was not bettered by the subsequent rally and hence the “bear” market remained in force. We had a new primary swing down and afterwards a new secondary correction which made a lower high. This “lower” secondary correction high was the valid high under Dow Theory to be broken. And eventually a subsequent rally broke on 09/13/2012 such high thereby issuing the Transports a bull market signal.

Thus, the basic idea of including the Transports as a valid index still holds true to this day and no reputable Dow Theorist has ever suggested that the Transports should be confined to the dustbin of history.

However, controversy among Dow Theorist does not finish with accepting the Transports. Some Dow Theorists (i.e. Russell) say that no other index may be added to the “mix”. Other Dow Theorists (Schaefer, Schannep) maintain that in times of Charles Dow or Hamilton there was no S&P or Nasdaq or even Utility index and hence they would have welcome any such addition, had it existed in their times.

Schannep thus considers that the S&P is the third index that should be considered when applying the Dow Theory. In his opinion is a very representative index because it includes NYSE and also NASDAQ companies with huge capitalizations thereby providing an accurate picture of the market. Furthermore, thorough tests conducted by him show that the S&P uses to be present in almost all Dow Theory signals with confirmation coming from either the Transports and/or the Industrials which reaffirms the leading role of the S&P in representing the market. However, in the rare occasions when a signal is given “the classical” way by just the Industrials and the Transports such signal is also taken.

Schannep also toys with the idea of including the NASDAQ. However, he refuses to accept the NASDAQ because of the following reasons:

a)     Stocks tend to go from NASDAQ to NYSE and not from NYSE to NASDAQ.

b)     NASDAQ stocks are not so representative of the broad market. Thus, Schannep notes that in the bear market of 2000-2001 one out of every ten stocks in the Wilshire 5000 fell 90% or more whereas none of such stocks was in the Industrials. In other words, the Industrials held up much better.

Schannep gives more reasons in his book which I omit here.

After analyzing in depth all these issues Schannep concludes that the NASDAQ is not the ideal index.

And what about the Utilities? Only Schaefer advocated for the very selective inclusion of the utilities as an index to monitor when trying to gauge the trend of the market. However, we should bear in mind Schaefer’s secular timeframe and that utilities are extremely sensitive to interest rates. Schaefer showed a nuanced interest in the Utilities in order to take clues as to the inception of a secular bull market.

On the other hand, less secular-oriented Dow Theorists like Russell argue against including the Utilities to the Dow Theory arsenal. In their opinion, which I share, the Utilities are too affected by interest rates and are not representative of the broad market.

So: What is my take on this?

Well, I personally consider that the Transports are still worthwhile because “aprioristically” it makes sense. If business is good in manufacturing companies, shipments should also benefit. The “built in” secular underperformance of the Transports does not bother me because, as I explained above, proper Dow Theory focuses mainly on relative secondary reaction highs (lows) and not absolute highs or lows (there are exceptions which will be the object of another post). And empirically, all the criticism notwithstanding, the “basic” version of the Dow Theory with its Transports is too good (even in recent times) to be ignored.

However, times change and adding the S&P as a third index to monitor doesn’t seem repulsive to me. Aprioristically, it makes sense. It is an index which truly reflects the broad market. Furthermore, for those NASDAQ friends, it includes more NASDAQ stocks than the Industrial index in its mix. Furthermore, empirically, its addition has greatly improved the “bottom line”, that is Dow Theory responsiveness. By adding the S&P the signaling of bull and bear markets is greatly improved. According to Schannep’s calculations the addition of the S&P resulted in ca. 2% improved performance for each Dow Theory signal (on top of the also excellent results of the “normal” Dow Theory which beats buy and hold by a great margin and with lower drawdowns).

In real life, adding the S&P means that a bull or bear market will be signaled when any two of the three indices confirm (i.e. Industrials and S&P, Transports and S&P, Transports and Industrials). This is the way I apply the Dow Theory.

Sincerely,

The Dow Theorist

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