Follow Your Gut, and Dow Theory

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David Evanson and Oliver Pursche

TheStreet.com, Fall, 2012

NEW YORK (TheStreet) — I have heard far too often (to the point of annoyance) that in a digital world, Dow Transportation stocks matter less in terms of their ability to predict where the markets are headed.

It seems as if investors forget that physical goods, including the service personnel that drive the service economy, cannot be transported through a computer. Everything still needs to be shipped.

Izzm inclined to believe paying less attention to the Dow Transportation stocks is a big mistake. I am not the first to say this, but instead reiterating advice that has proven reliable and successful.

Specifically, one of the six basic tenets of the Dow Theory is that the Dow Jones Industrial Average and the Dow Jones transportation index should move in the same direction. When the averages diverge, itzzs a warning that change is coming and likely not positive change.

I feel the warnings issued by FedEx (FDX), Norfolk Southern (NSC) and Caterpillar (CAT) two weeks ago, was the first alarm bell. Unfortunately, this warning was shrugged off by stampeding bulls.

From 1953 to 2011, incorporating the tenets of Dow Theory — which includes paying attention to the transports — has produced an excess return of 1.5% annually over a buy and hold strategy. This was the conclusions of a study marking the 160th birthday of Charles Dow. For many years the Dow Theory was discarded, but a newer analysis found that on a risk adjusted basis, Dow Theory delivers alpha.

I would remind investors that alpha works to the downside as well as the upside. That is, losing less than the markets at large is, in the twisted scorekeeping of investors, a win. Itzzs true, investors should never use a single indicator as a guide to decision making.

However, if the trend in transportation stocks is another data point confirming your suspicions, I would urge you to follow your gut and take some risk off the table.