As Sam Sees It: What to Make of the Dow Theory

Sam Stovall |

Each week, we tap the insight of Sam Stovall, Chief Equity Strategist for S&P Capital IQ, for his perspective on the current market. 

EQ: In this week’s Sector Watch report, you took a look at the Dow Theory. What is the premise of the Dow Theory and how is it supposed to work?

Stovall: The Dow Theory says that if you have an upward move in the Dow Jones Industrial Average, you should also have a confirming upward move in the Dow Jones Transportation Average. Similarly, if you have a downward move in one, you should have a downward move in the other. So basically, they should move in lockstep so that one ends up confirming the other.

EQ: That lockstep behavior has not been happening. You analyzed the growing divergence between the DJIA and the DJT. What does that suggest about the market?

Stovall: Well, what it suggests is that the DJIA has been outperforming the DJT on quite a significant level since the beginning of this year. For those who follow Dow Theory, it’s a bit of an ominous sign. Because of this divergence, the implication is that the broader market is setting itself up for a disappointing move since its recent highs have not been confirmed by recent highs in the Transports. So the reason why I wrote about the Dow Theory is because it seems to be getting so much press these days and I wanted to see if it could be applied to a rules-based investment approach. Unfortunately, I did not find that it easily lent itself to such.

EQ: As you mentioned, the Dow Theory is certainly getting picked up in terms of media attention right now. That, in turn, seemed to spark a conversation about the relevancy of the indicator. Some commentators even called it ancient. In your opinion, is it outdated or is there still a use for it in today’s market?

Stovall: I still think there’s a use for it, because what it does is it measures the economic connect or disconnect between the overall economy and the transportation side of the economy. Let’s face it, businesses and consumers still order and receive raw materials and finished goods. So until we develop a Star Trek-like transporter, we’re going to need planes, ships, railroads, etc. to transport raw materials, aggregates, chemicals, etc. to the factories, and we’re going to need those same transportation methods to then transport the finished goods to the individual consumer.

You could probably add drones to that transportation grouping as well, but what I think it simply implies is that even though our method of ordering things has changed, going from brick and mortar to doing so online, the fact that they still need to be delivered to us, indicates that transportation is still a very important component in economic activity.

That said, I do think, however, that investors should not just look at the DJIA and DJT divergence at face value and think we’re heading for a decline because it is much more of a soft, time-unspecific indicator and is probably better used with other measures of market health before deciding that a new bear market is around the corner.

EQ: You also noted that S&P Capital IQ’s Investment Policy Committee shifted more toward a recommendation to raising cash allocation. Do you think the downside risk in the market has increased recently?

Stovall: Yes, I do. We’ve gone even longer at 45 months without a meaningful decline. Valuations, I think, do look a bit challenging—to put it in a nice way. Only when you overlay an inflationary environment of 1.5% or less do we find that valuations are pretty much at fair value. Any inflationary measure above 1.5% then points to the market trading at a historical premium. So what we did was, by looking at the Dow Theory as well as many other indicators, we felt it was best to pull back on our equities exposure, which had recommended an overweighting to US equities. We are now recommending neutral exposure to both US and foreign equities.

When we took 5 percentage points away from the US and needed to re-allocate elsewhere, we decided to put it into the fixed-income side, part of which is our cash allocation. Normally, we have a cash allocation of 10%. We elevated that to 15% because we are in the seasonally soft period for equities and we just believe that the market is vulnerable to some sort of a setback, at which point we would be willing to consider adding that 5 percentage point back to equities.

EQ: On the note of where valuations are right now, you were recently on CNBC discussing the recent pick-up in M&A activity in the market. Are corporations seeing value in the market where they are right now, or are they trying to get these deals done while interest rates are still this low?

Stovall: Well, I think they see favorable valuation in their currency, which happens to be their stock price. Early in the M&A cycle, typically companies use cash to purchase other companies. As the M&A cycle matures, it becomes a combination of cash and stock, and then when the market has heated to the point where stock valuations look very high, companies tend to use their overpriced stock to purchase other companies. By engaging in this acquisition game, however, I think that’s a positive sign because it implies that companies believe there is growth potential in the industries that they are buying into. They may be looking in their own industry or to areas where they’re looking to expand, and they feel it’s better to do so by buying a company with good products and good market share rather than by trying to create it on their own.

For more from S&P Capital IQ, be sure to visit www.getmarketscope.com.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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