As an investment analyst, we’re always looking for signs.
Not road signs.
Not star signs.
And not signs from the tealeaves or other such hocus-pocus.
We’re looking for market signs — a sign from other investors, or from the market, to give us a clue about where the market is going next.
There’s one sign we’ve followed for some time. For a while, it looked bullish. But now it’s looking bearish again.
That should be a big worry for investors…
Your editor isn’t a chartist or technical analyst.
We openly admit that we don’t understand most of the lines or indicators that chartists stick on their charts.
We’re a fundamental analyst. We like looking at the big idea behind a company. We like to see how a company makes money…and how it (hopefully) makes a profit.
That’s how we make our investment decisions. That said, there is one chart that has caught our eye for the past two years.
What we don’t know about charting
As we say, we don’t know much about charting. We don’t know an Elliot Wave from a Mexican Wave. We don’t know a Fibonacci sequence from a DNA sequence. And we couldn’t tell you the difference between a Gann Fan and an electric fan.
But we do know one thing. We know logic when we see it. That’s why we’ve become so enamoured with the ‘Dow Theory’.
Now, the Dow Theory can be somewhat complex. And even its devotees have points of difference on how to interpret the charts.
But at its simplest, the Dow Theory says that in order to validate a bull market for the Dow Jones Industrial Average, you need to see a corresponding bull market in the Dow Jones Transportation Average.
When both are at a new high, that ‘confirms’ the bull market. Now, to be clear, just because one is at a high and the other isn’t, that doesn’t mean it’s not a real bull market. It just means the price action hasn’t confirmed it.
So, how has the Dow Theory played out in recent months? Check out the five-year chart below. The Dow Jones Industrial Average is the white line, and the Dow Jones Transportation Average is the orange line:
[Click to enlarge]
You can see that over the past month, both averages have soared to record highs. That should be confirmation of the bull market.
It’s especially interesting because the Transportation Average (white line) had failed to get anywhere near its high over the past year or so.
But now it has. Bull market, right? Not so fast. Check out the shorter-term chart. This covers the past month:
[Click to enlarge]
You can see that while the Industrial Average (orange line) has remained at or near its high point, the Transportation Average has slipped back.
Arguably, the Transportation Average is no longer ‘confirming’ the bull market. As we say, the Dow Theory is open to interpretation. Furthermore, it’s not realistic to expect two different indices to move step-for-step every single day.
Supported by logic
However, it still could be significant. The reason Dow theorists look at the relationship between these two indices is transportation stocks give you a clue about the movement of goods between and across an economy.
If industrial companies are making things, but it’s all being warehoused, that could suggest there isn’t a current demand for the goods from businesses and consumers.
In other words, you want to see that freight companies are actually shipping the products that industrial companies are making.
For that reason, it’s fair to ask whether the current rebound in stocks is genuine, or whether it’s just a hubristic response to the recent US election result.
While in one way it’s good that US interest rates are rising, there can also be little doubt that rising interest rates will harm heavily indebted businesses and consumers.
And that will affect the profitability of those (and other) businesses, and the ability of consumers to buy those products. It’s a double whammy. And that must surely be bad news for stocks.
That’s why we like the Dow Theory, and the charts that support it. It’s not based on squiggly lines, or so-called support and resistance lines, or other such questionable methods.
The Dow Theory uses logic. The kind of logic any fundamental analyst worth their salt should be able to understand.
For The Daily Reckoning
Editor’s Note: This article was originally published in Money Morning.