Will This Century-Old Theory Really Send Stocks Into a Correction?

By Markets Fool.com

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Will this man bring on the next market downturn? Image of Charles Dow courtesy Wikimedia Commons.

After several years of moving nearly straight up, the stock market has given investors a much more mixed performance so far in 2015. Even as theDow Jones Industrials and other major market benchmarks have set new all-time or multiyear highs, investors worry about the prospect for a long-awaited downturn. Now, a rising chorus of concerned market commentators is proclaiming warning signs from a theory whose origins date back more than 100 years, with the expectation that a correction in the Dow could be imminent. The key is the transportation sector and whether it can pick up the pace after lagging slightly to start the new year.

Dow Theory is back
Most investors celebrated the Dow's latest record high early this month as confirming the continued strength of the 6-year-old bull market. But those who follow what is known as the Dow Theory weren't convinced, because they wanted confirmation from another key Dow average: the Dow Jones Transportation Average . Unlike the Industrials, the Transports have not set a new all-time high in 2015, with their closing record having come late last December. Dow Theorists argue that the two averages must confirm each other's movements, or else a reversal in the market's direction is likely to follow.

Looking at the Transports, there is definite dissent within the ranks among different groups of stocks. Airlines continue to perform quite well, particularly the smaller regional airlines in the group. JetBlue leads all transportation stocks since the average's December high, with a gain of almost 25% coming as the airline enjoys the benefits of lower fuel costs and more favorable traffic numbers than even some of its major peers.


FedEx stock hasn't flown higher in 2015. Image: FedEx.

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On the other hand, much of the pressure on the Transports has come from the railroad and shipment-logistics sectors. Regional railroad Kansas City Southern has lately posted the worst losses in the average, falling 15% since late December, but all three of the other major railroads in the average have also fallen over that time frame. Perhaps most importantly for those who believe in the economic underpinnings of the Dow Theory, both FedEx and United Parcel Service have declined this year, with UPS falling more than 11%.

Should you believe in the theory?
The rationale put forward by modern-day Dow Theorists is that the transportation sector is a good indicator of economic activity, as it supports the movement of goods throughout the manufacturing and consumer economy. Reduced transportation activity can serve as an early warning that those companies' customers aren't seeing as much demand for products to sell, and that in turn can signal an economic downturn that would presumably pull the entire stock market downward into a correction.

Still, like any indicator based on past price information, the Dow Theory doesn't have a perfect track record. Conditions were strongly favorable to transportation stocks in December, with energy prices hitting multiyear lows and robust levels of demand still supporting growth in most of their respective industries. Now that investors already expect big boosts in earnings this year from fuel savings throughout the sector, it will be harder for the Transports to produce positive surprises, and that in itself could hold back share prices even if those businesses remain healthy enough to support economic growth and broader stock market gains.

Keeping an eye on other stock market measures is always a good idea just to stay informed about what is happening throughout the financial world. Although corrections will inevitably happen regardless of what Dow Theory says, any signal from the Transports doesn't automatically mean that correction will occur in the immediate future.

The article Will This Century-Old Theory Really Send Stocks Into a Correction? originally appeared on Fool.com.

Dan Caplinger has no position in any stocks mentioned. The Motley Fool recommends FedEx and United Parcel Service. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.