Why Dow Theory Doesn't Work
Dow Theorys' author, Charles Dow, theorized a relationship existed between the Dow-Jones Industrial and Transportation Averages that could be used to forecast business cycles. In the early 20th century, the Dow Jones Industrials consisted primarily of thirty blue chip manufacturing companies called "smoke stacks". The twenty Transportations consisted primarily of railroads. The "rails" delivered raw materials to the "smoke stacks". The business cycle was characterized by phases identified as prosperity, recession, depression, and recovery. By noting the relative price action between the industrials and the transportations, it was believed that an astute investor could determine when the economy was shifting from one phase to another and act accordingly. Regardless of how useful Dow Theory may have been then, can the same be said now, given all the component changes that have taken place within those averages? I think not. Today the "smoke stacks" have been replaced by the "service" economy. Instead of steels, chemicals, mining companies, etc., we have software, fast food, amusement parks, insurance, financials, credit cards, etc., etc., etc. The rails have been replaced mostly by airlines which, most decidedly, do not deliver raw materials to heavy manufacturers. Can we still say the same relationship between the industrials and transportations exists??? If "chartists" are confused when one average refuses to confirm the other, this could be the reason.
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