Ashraf Laidi: FTSE 100 Five-Year Anniversary & Industrials/Transportation Divergence.

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 direction.

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.