Note: DowTheory failed spectacularly in 2006, but worked remarkably in 2007.
On the day of the 5-year anniversary of the FTSE-100’s record high,
BoE governor hinted that price stability may no longer need to be the
Bank’s sole objective.
Is this what it takes to keep new market anniversaries going?
Meanwhile, there are serious rumblings about the Dow Theory.
According to Dow theory, created by Charles Dow, founder of the Wall Street, a divergence between the Dow Jones Transportation Average (DJTA) and the overall Dow Jones
Industrials Average (DJIA) is indicative of upcoming trends in the
general economy as signalled by transportation stocks. Thus, an extended
decline in the DJ Transportation Average, accompanied by a rise in the
broader 30-stock average, reflects falling demand in shipping and
transportation orders. Such divergence would eventually be reflected in
the rest of the economy with varying time lags. Any deepening divergence
between the two indices, would suggest that Transportation index would
prevail, and the broader average (and the economy) would move in its
So far this year, the Dow Jones Transportation Average is down 5.0%,
while the broader average is up 11.0% and the S&P500 is up 16.0%.
As we watch this important divergence, we must bear in mind two factors:
The Federal Reserve’s third round of quantitative appears to be easily
weighing on bond yields and boosting financials, Internet stocks and
basic materials, all of which comprise the broader averages. Meanwhile,
Dow transportation stocks, have been damaged by a combination of
uncertainty related to the US “fiscal cliff” and recent profit
downgrades, warning that Q3 earnings season would be the worst since the
height of the financial crisis.
The success rate of the Dow Theory was most remarkable in summer 2007, three months before equities began their two-year slump. But the theory was also flawed in summer 2006 when the Transportation index fell 15% only for the Industrials Average to rally onto record highs in the subsequent 12 months.
As the bears grow in confidence from the prolonged divergence, the
questions to ask are whether the Fed’s stimuli would reverse the
Transportation index; and; if it did materialize, would it be only for a
limited period of time?
And so will the negative implications of the Dow Theory survive the
novelties of central bank stimuli? The ECB’s Outright Market Transaction
program stands out from prior bond purchase plans via its ability to
combine conditionality, sterilisation and unlimited purchases. Last
month, the Federal Reserve relegated price stability objective while
giving more emphasis to reducing unemployment. Today, BoE’s Mervyn King
hinted that price stability may no longer need to be the Bank’s sole
objective. The 2.0% inflation target was set in 1997, coinciding with
new-found independence of the central bank.
It could well be that central bank stimuli may stabilise the
Transportation average and get it to turn back around thanks to a
positive transmission mechanisms from equities into the economy? Such
dynamics occurred in late 2010 onto early 2011 and may not be so
inevitable this time around.