Correlation: The Dow Theory

Peter Schiff's Radio Show has reminded me that there is a correlation in the Dow Transports Vs. Dow Industrials.

He said in the 26 February 2013 radio show that when the Dow Transports doesn't go up together with the Dow Industrials, then it is likely that the Dow Industrials will go down. That's the Dow Theory.

The definition of the Dow Theory goes like this:
In Dow's time, the US was a growing industrial power. The US had population centers but factories were scattered throughout the country. Factories had to ship their goods to market, usually by rail. Dow's first stock averages were an index of industrial (manufacturing) companies and rail companies. To Dow, a bull market in industrials could not occur unless the railway average rallied as well, usually first. According to this logic, if manufacturers' profits are rising, it follows that they are producing more. If they produce more, then they have to ship more goods to consumers. Hence, if an investor is looking for signs of health in manufacturers, he or she should look at the performance of the companies that ship the output of them to market, the railroads. The two averages should be moving in the same direction. When the performance of the averages diverge, it is a warning that change is in the air.

So if you see that the Dow Industrial goes up, while the Dow Transport doesn't go up, you're in trouble.

Now back to Peter's case. He said that the Dow Transportation Average didn't confirm the rise in the Dow Industrial Average on 26 February 2013. That was true, but if you look at a longer term, the Dow Transportation average has outperformed the Dow Industrial Average (Chart 1).

So this is one of those times I actually don't agree with Peter.

Chart 1: Dow Jones Transportation Average (blue) Vs. Dow Jones Industrial Average (red)

This makes me want to go further in my analysis. Let's subtract both indices from each other, take the percentage change on it and see what happens (Chart 2).

Chart 2: DJTA - DJIA (Percentage Change) Vs. DJIA

As you can see, each time the DJTA goes up more than DJIA (blue chart moving up), the DJIA will go up. And each time we see a spike lower in the blue chart, we hit a recession or a stock market crash.

At this moment we don't see any of such things happening in the blue chart, so I believe the stock market is pretty stable at the moment.