Why the Old School Dow Theory Still Applies

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Why the Old School Dow Theory Still Applies

Getting a sense of where stocks are going to go in the year ahead is always difficult with the major indices at their all-time highs.

The fundamental backdrop is still very favorable for equities. While the Federal Reserve has put off raising interest rates for the near future, the cost of capital, especially for corporations, remains extremely low. And corporate balance sheets remain in excellent condition with strong cash positions and good prospects for rising dividends going forward.

The stock market recovered extremely well from the financial crisis and subsequent crash in 2008/2009. But it wasn’t until early 2013 that I saw the beginning of a new cycle for stocks, or a bull market as it were.

Until then, I viewed the market’s performance purely as a recovery period from the previous cycle, which was the technology bubble.

Many of the technology stocks have only now recovered to their previous highs set in 1999 and 2000. The recovery cycle took a long time to play out and the catalyst for its breakout was, not surprisingly, the Federal Reserve.

Stocks can move significantly higher in a rising interest rate environment, but only from a low base, which is what we have now. And within the context of a new market cycle or bull market, the economy can experience a full-blown recession and stocks can experience meaningful corrections.

The two most important catalysts for the equity market near-term are what corporations actually report about their businesses and the Federal Reserve’s actions.

The surprising weakness in oil prices should be evident in corporate financial results (especially in the fourth quarter). Old economy industries that consume vast amounts of fuel, such as railroads and airlines, should see some benefit to earnings. This bodes well for stocks in general.

Second-quarter earnings, especially among large-caps, was better than expected and corporations underplayed their outlooks for the bottom half of the year, making it easier to “outperform.”

It is a game, of course, and outperformance on at least one financial metric (revenues or earnings) is what the Street wants to see.

In terms of where stocks are going in 2015, I think it’s still relevant to follow transportation companies both in terms of their financial performance and stock market action.

The Dow Jones Transportation Average has been a leading index since the 2013 breakout, and it’s highly likely to be a key predictor at this early stage in the cycle.

And it’s still hitting new record highs. Within the index, stocks like FedEx Corporation (FDX) and Union Pacific Corporation (UNP) have been helping tremendously and they themselves are great predictors for the broader market.

So much has changed in terms of technological innovation and business models, but old school DOW theory still applies to the equity market today.

While central bank action and corporate financial results are the two greatest arbiters of the stock market, within the system, the most important stocks to follow are in transportation. Where they go, the rest of the market follows.

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