Back in the late 1800's when the Dow Theory was conceived, the U.S. economy was transforming from agrarian into conglomerates of "smokestack" industrial industries, spawned by the Industrial Revolution at the turn of the century. These new industries created the need to transport the steel, iron ore, aluminum and textiles required to produce and distribute the products to consumers as growing demand fueled the new industrial economy.

Dow Theorists maintain that for any new high in the Dow-30 to be a legitimate indication of economic expansion and sustainable higher stock prices, the companies required to transport the commodities and distribute the manufactured products must also reach new highs within the Dow Transports. Without confirmation from the rails, shipping, over-land carriers and later the airlines, any new high on the Dow-30 is ephemeral and the valuations of the underlying Dow-30 stocks are overvalued and unsustainably overpriced.

The Dow Theory is based upon the confirmation of an ongoing trend and many Dow Theorists extend this concept to include trends in either of the indices. They argue that when either the industrial average or the transportation average breaks above a previously established high (i.e., prior resistance), it must be accompanied by a breakout in the other average in order to confirm the trend. Such confirmation signals that the prevailing trend of the market will continue. Conversely, Dow Theorists argue that when both averages fall below previously important lows (i.e., prior support) a downtrend is confirmed and lower equity prices within the downward trend will prevail.

Is Dow Theory Still Relevant?

Today, many observers argue the Dow Theory has outlived it's usefulness as an effective market indicator given our new service-oriented and technology-dominated economy. However, just as the nature of the economy has changed so has the composition of the Dow Jones Transportation Index. Once totally dominated by railroads and overseas shipping companies, the index is now comprised of modern transportation companies that move the materials, commodities, finished products and people needed to design, manufacture and distribute the products and services of the new economy.

Additionally, the growing global economy has placed added emphasis on the "Trannies" as technically advanced production and manufacturing techniques require expanded and critically efficient methods of transportation, inventory management and product distribution worldwide.

I believe the relevance and predictive value of the DJTA is every bit as useful today as it was when coal-fired smelting plants covered the Midwestern landscape from Detroit to Pittsburgh. In fact, along with the anticipation of the Fed turning more accommodative, global economic growth and a falling bond market, one of the major indicators that kept me bullish throughout this record run for the Dow-30 was the breakout in the DJTA this past September. That was classic Dow Theory in action.

As the weekly chart below shows, the DJTA pulled back, along with the over all market, from its May high of 5013 to a low of 4134 in early August. The index then put in a base throughout August before breaking out in early September and running toward 4900 in November. 

As concerns in late December arose over the slowing economy and the prospects of a "soft landing" dwindled, the DJTA pulled back but held its 50- and 200-period moving averages on the weekly chart. This action allowed me to maintain my bullish posture and remain fully invested throughout the period of market uncertainty.

With the arrival of the New Year, the Transports rallied as the Dow and S&P continued to make new highs. This ongoing positive action in the DJTA confirmed the continued rise in the Dow and once again The Dow Theory's validation of the move proved to be a correct confirmation.

After basing through the middle of January and holding the 50-day moving average above 4700, the DJTA has exploded to the upside closing up over 6% this past week. More importantly from a Dow Theorist view, the DJTA has confirmed the continued new highs in the Dow Industrials by making an all-time intraday high Friday at 5032.41, eclipsing the May high of 5013 before closing the week at 5006.89.

A Modern Modification to the Dow Theory

Over the years I have modified the original Dow Theory by adding an additional indicator. I began by following the "deep cyclicals" as illustrated by the Morgan Stanley Cyclical Index and later adding them to the confirmation process.

What became apparent was that the price action in these industrial cyclicals also acted as confirmation for the DJIA and DJTA, further validating the Dow Theory. Notice in the chart of the Morgan Stanley Cyclical Index below how it mirrors the Dow and the Transports though the only transports in the index are CSX, FDX and R and the remainder of the index includes names such as DD, DOW, ETN, GT, IP, IR, JCI, PD, TIN and WHR -- all cyclical stocks that are not included in the DJIA.

This demonstrates that the price action of the industrials and transports during sustained bullish or bearish economic conditions should be further confirmed by the MS Cyclical Index. The price action among these three related indices should confirm the underlying stock valuations within each index.

Currently, during this period of continued GDP growth with minimal inflationary pressures and a reduction in inventories with rising commodity demand the deep cyclicals have risen to new highs in conjunction with the DJIA and the DJTA. This is precisely the price action and confirmation the Dow Theory requires to validate this market as all three indices are breaking out to new highs.

The same reasoning will apply and should be monitored to the downside. The supply and demand equation for manufacturing and production should be equally demonstrated by the need for transportation of raw materials and the ultimate product distribution of the heavy industrial cyclicals. Applying the Dow Theory, once the price action confirms a change to a downward trend it will be time to book profits.

My buy and sell disciplines, including technical indicators, fundamental analysis and macro economic factors will include the interaction of these three related indices as applied by the Dow Theory to determine stock valuations and future market action. I urge you to do the same.

Carl Mathison is Yachtsman