Does the Dow Matter?

Dow Theory relies on price action in the Dow Jones Industrial Average (Dow) and the Dow Jones Transportation Average (Transports) to determine the primary trend of the stock market. Among the main tenets of Dow Theory is that moves in each index must confirm one another. If the Transports and Dow set new lows at the same time, the primary trend is bearish. If the two diverge, with one setting a new low and the other refusing to confirm, the divergence indicates the possibility of change.

Until a week ago, the possibility of divergence existed. Unlike when markets crashed to new lows in a synchronized manner in November 2008, 2009 saw certain marks break lower while others held steady. Holding hope that the divergence would reverse the primary trend, I cautioned investors to watch closely. If the markets could move higher from this non-confirmation, the trend would change and we could safely reenter the markets.

The following chart compares the market lows reached last fall with the lows reached last week:

Index	Market Low	Date of Market Low	Recent Low	Date of Recent Low
Dow	7,552	11/20/08	7,553	2/17/09
Transports	2,804	2/17/09	2,804	2/17/09
NASDAQ	1,316	11/20/08	1,440	1/20/09
S&P 500	752	11/20/08	789	2/17/09
FTSE 100	3,781	11/21/08	3,999	2/18/09
DAX	4,127	11/21/08	2,849	2/18/09
NIKKEI 225	7,163	10/27/08	7,534	2/18/09

As markets moved in unison to the downside on Tuesday, the Transports set a new low and the Dow rested less than one point above a new low. However, the other markets have left some room for optimism. They've hit 2009 low points, but remain above the market bottom of November 2008. Therefore, investors must now question whether we are seeing a divergence that could change the primary trend or if a confirmation of the bear market lies around the corner.

Those looking for divergence cling to aspects of the Dow that they believe minimize its effectiveness as a market proxy. The Dow is a price-weighted index where the higher the stock price, the more it affects the index's value. As many financial companies have plunged in value, the Dow is littered with sub-$10 stocks that have little impact. Consider that Bank of America (BAC), Alcoa (AA), Citigroup (C), General Motors (GM), and General Electric (GE) have a combined weighting of 2.9%. If all five were to go bankrupt the U.S. economy would be devastated, yet the Dow would fall only 220 points. Such disconnect between the value of the Dow and its impact on the economy leaves many believing the Dow does not matter.

If you trust this thought process, you are comforted by the ability of the NASDAQ (QQQQ) and S&P 500 (SPY) to remain 9% and 5%, respectively, above their November lows. I find such comfort to be misplaced. With respect to similar groups, whether individual stocks or broad markets, divergences almost always result in lower prices. Instead of the weak stock rising in value to meet the stronger stock, the stronger usually breaks lower and confirms the bearish nature of the weaker. In the current environment, I expect the same pattern to hold with the Dow officially confirming the bear market in coming days and the NASDAQ and S&P 500 to weaken as well.

Six weeks into a new year, drama continues to unfold. I started the year with a fair-value target on the S&P 500 of 625. After the S&P 500 experienced its worst January ever, markets began firming and offered hope that the primary trend could change. As those hopes have been dashed, we are confronted with the realistic possibility that the S&P will approach my fair-value target and that it will take the Dow below 6,000.

Having suffered enormous loss of wealth over the past year, investors now must reassess their game plan. Expecting much lower prices, an exposure to stocks should be limited. However, bonds and cash pay minimal interest and have little value as long-term investments. Shorting makes sense to some, but strong bear market rallies can devastate a portfolio. Searching for return, I believe quickly realizing profits will prove the best long-term strategy. Remain hedged and book gains when they reach a reasonable level. Doing so will keep you liquid, solvent, and prepared for the time when this bear market eventually bottoms.

Comments

[morph366:]

Your observations regarding the usefulness of the DJIA are well made - but it still is the most widely quoted index all over the world.
From a technical point of view the Nasdaq 100 index is one of the most useful - especially in recent times - because it avoids the financials. Reviewing its performance in current sessions - it is still showing evidence of being in a protracted trading range.

Feb 19 06:33 AM

[deflation r...:]

Yes, the Dow does matter. It is a commly followed and understood metric that the layman investor can use to judge the health of the market.

Feb 19 06:34 AM

[ROLEXDAYTONA:]

I trade mostly Dow futures, very often I don't even know the numbers for Nasdaq or even SP, only when I decide to trade SP futures I look at the quote.
DAX,FTSE,NIKKEI,CAC,SM... I don't know what is their quote exectly, only Dow I follow.
But I don't know the exact reason why all the world look at the Dow, it may well be a nonsense and mistake, only time will show if Dow really matters the most.

Feb 19 07:23 AM

[Moon Kil Woong:]

I think the DOW is followed bcause more than any other index it tracks the large caps and sincre it's weighted like it is it favors the rising large caps. So if you want a more representstive of the whole market you would never pick the DOW, but if you wanted to track the big name stocks with relative ease you'd find it easy to do just by looking at the DOW.

Face it, most individuals and large cap funds and investors are heavily weighted in liquid large caps. That's why it is so readily followed.

Feb 19 12:02 PM

[softomic:]

The Dow matters. Even though it is price weighted, the company selection process and the general market acceptance of the index ensures that it is a good gauge of the economy. If the company selection was automated somehow, then I don't think it would be any good.

The VIX, however is a different story.
seekingalpha.com/artic...

Feb 19 12:51 PM

[User 360489:]

Dear Ralph,

You are only half correct, which is about the best I can hope for from someone who rails against 401k plans. My guess is you don't make enough money for it to matter, but I will be generous and break down for you why all of us "Chumps" are investing in 401k plans at work.

1) Employer Match = Free Money. Only an idiot wouldn't want free money. Can be anywhere from 3 - 6%+ of your salary. The higher the salary, the higher the $ amount of the employer match. A fair system for all.

2) Tax incentives, tax incentives, tax incentives. Using your casino analogy, if you were stepping into a casino would you prefer 25% more money to start gambling with for doing nothing. Of course you would, who wouldn't. That's how a 401k works. You can contribute up to $16,500 a year toward your long term savings/retirement tax free. If I am saving this money toward long term savings/retirement anyway of course I would like to start my COMPOUNDING with 25% more at day one. Try a financial calculator on the internet and see where you would be saving $13,200 (after tax amount) versus $16,500 (pre-tax amount) in 35 years. Nevermind, I'll save you the trouble. Assuming a conservative 5% interest rate compunded monthly you would have $1.33MM versus $1.66MM. Gee, guess which one I would rather have when I retire?

3) This is really where your casino analogy falls to pieces. With the stockmarket (as opposed to a gambling casino) you are actually buying a tangible piece of a company that is (hopefully) earning money or plans to at a future date. Since I am not a business owner through a sole prop or a partnership this is another way for me to own a business (loosely used) and let my money work for me/earn more money.

Banks are a fine place to park your money until you want or need to buy something, but let's face it they are the ones profiting from your money by loaning your money to others, well them and their shareholders. :) Another alternative is to invest in collectibles, but then you are speculating that someone else will appreciate the collectible as much as you in the future and will pay more for it. That's pretty risky if you ask me, especially if your not an expert in that collectible. The last alternative I can think of is to spend your money as fast as you get it, but obviously this carries a risk and chances are you will have a bunch of stuff you don't need. I feel the best alternative for me and countless others is to place long term savings/retirement is in stocks of companies that I feel will generate revenue in the future and then manage those holdings the best that I can by being current on their issues. Pretty simple really when you think about it.

On Feb 19 07:08 PM RICHARD RALPH ROEHL wrote:

> Dear 401K Chumps:
>
> The $tock Market is a casino. Investing in $tocks is playing poker.
> It is a game... and often rigged for the $ake of the House (Wall
> $treet brokers).
>
> Okay chumps! Here's news that you (in lieu of ewe) can use.
>
> There are TWO rules in poker.
>
> Rule 1. says you gotta know when to hold 'em (the $tocks) and when
> to fold 'em. Buying and holding (butt never $elling) is a $cam for
> naive 'Ma an' Pa folks' who haven't a damn clue what Wall $treet
> really is.
>
> Rule 2 is so obvious that even the pros forget about it. Indeed!
> Rule 2 is the most important rule. Listen up! Rule 2 say... NEVER
> HIRE $OMBODY TO PLAY POKER WITH YOUR MONEY.
>
> You got a 401k? 403b? 529? Ira Roth? Annuities? Keogh Plan? Perhaps
> some other 'mutual fund' paper? Well... you are a chump!
>
> Finally this: Where there is no insight, the people perish. And whom
> the gods would destroy, they first make mad... off. Yes, Bernie Madoff
> is in his 10 million dollar apartment in Newe Yawk! Newe Yawk! You
> are in the $treet holding the bag... or maybe a tin cup.

Feb 19 07:58 PM

[iknoknot:]

deflation rocks indicates the Dow (DJIA) as being useful as a layman's metric.

With all due respect, I'm not buying it, mostly because the historic graph seems to always go up. Considering "survivor bias", how many of today's Dow companies have been there since it was established as an index? All the dead ones have been replaced with newer shiny models... No wonder the graph averages up. Then consider the inflation graph paralleling the Dow. Subtract that bias, and perhaps the Dow would be more meaningful.

I prefer an inflation-adjusted DJ Wilshire 5k... (using John William's shadowstats as an inflation basis...)

best

--ikk

Feb 19 11:55 PM

[Conan the B...:]

DJIA: Dow Jones Industrial Average.

The makeup of the Dow 30 No Longer reflects an Industrial Bias. Industrials were "Once a Upon a Time" the basis for the US Economy. As the Economy changed, the DOW started reflecting Non-Industrial Stocks. Some times the replacements were just the High Flyers of the time.

While DOW Theory remains, the makeup of the DOW has been skewed to reflect the Popularity of the companies included rather than a true reflection of the actual economic conditions.

Of the Original 12 Components, GE is the Last Man Standing. 12 not 30.

When the Components of an Average have been altered to such a degree that the Original Theory can no longer be applied accurately, then the theory becomes irrelevant.

People will still use it, I don't. I prefer the S&P or the strictly Common Stock components of the NYSE or 1700 stocks within Value Line but certainly not the Corrupted Version of what is Called the DJ Industrial Average.

Oh, sure, I will use it to make a point on how good/bad things look but The S&P is really the main tool.

IMHO

Feb 20 12:40 AM

[sr9web:]

S&P 100 is best index to follow


On Feb 19 12:02 PM constructe wrote:

> I think the DOW is followed bcause more than any other index it tracks
> the large caps and sincre it's weighted like it is it favors the
> rising large caps. So if you want a more representstive of the whole
> market you would never pick the DOW, but if you wanted to track the
> big name stocks with relative ease you'd find it easy to do just
> by looking at the DOW.
>
> Face it, most individuals and large cap funds and investors are heavily
> weighted in liquid large caps. That's why it is so readily followed.

Feb 20 01:07 AM