Why the Dow industrial and transportation divergence may be ominous

Ashraf Laidi
Dow Theory is becoming hard to ignore. Created by Wall Street Journal founder Charles Dow, it suggests that divergences between the Dow Jones Transportation Average (DJTA) and the Dow Jones Industrials Average (DJIA) indicate future trends in the economy. Deep divergences between the two could mean that the DJTA would prevail, and the DJIA (as well as the broader economy) may follow its lead.

The DJTA is down 5 per cent this year, while the DJIA is up 11 per cent. We must bear in mind: the Federal Reserve’s third round of quantitative easing appears to be weighing on bond yields and boosting financial, internet and basic material stocks, which comprise the broader average. Meanwhile, transportation stocks have been damaged by uncertainty related to the US fiscal cliff and recent profit downgrades, warning that third quarter earnings season could be the worst since the height of the financial crisis.

The success of the Dow Theory was seen in 2007, three months before equities began their two-year slump. But the theory showed flaws in 2006 when the DJTA fell 15 per cent, only for the industrial average to rally to record highs in the subsequent 12 months.

As bears grow in confidence from the prolonged divergence, the question is whether the Fed’s stimulus will reverse the DJTA. Will the Dow Theory be right again?

Keep informed with the expert opinion of City Index’s chief global strategist, Ashraf Laidi: www.cityindex.co.uk/market-analysis