source: wikipedia
This gets my blood boiling.
http://www.investorplace.com/2012/04/dow-theory-doldrums-a-bit-misstated/
To me, this is a classic case of people reading the surface 'information' without understanding context.
Here is another article that refutes some of the more ridiculous claims of folks who dismiss Dow Theory, and somewhat deals with the topic of today's discussion.
http://seekingalpha.com/article/281489-dow-theory-continues-to-be-misunderstood
I hear a lot of people talking today about how Dow's theory is no longer applicable. The jist of the argument is that the transportation average isn't made-up strictly of transportation sector companies, and includes companies across a variety of sectors. Thus the Dow Jones industrial average doesn't represent transportation the same way that it used to, and so it can't reflect the same relationship that it did when Dow created his theory over 100 years ago. Likewise, the Dow 30 is made up of companies from a variety of sectors, and includes companies like Walt Disney, AT&T and Microsoft. Thus the Dow 30 doesn't reflect industry like it used to, and furthermore can't reflect the same relationship as it used to. Because of the change in make-up of each average, and because our economy has changed so radically over the past 30 years, the relationship between the two averages is argued to be fundamentally unreliable.
Wrong.
The missing piece is that the fundamental relationship between the Dow transportation average and the industrial average lies in the truth that in any economy there are companies that make the things people buy, and there are companies that deliver the things which are made. This fundamental make/deliver (read: supply/demand) aspect of the economy never changes; its only the context that changes.
Increasingly, these lines are blurred as companies engulf other companies and take on more of each side of the supply/demand equation as a conglomerate. Remember though, that there are always aspects of delivery and manufacturing that require extra players. For example, in the Dow 30 index, Dell doesn't itself own and operate a delivery mechanism for its computers. They source it out to someone else. So Dell is the maker (supplier/manufacturer), and FedEX or UPS deliver (transport/fulfill the demand). Likewise, McDonalds uses regional suppliers for its produce, meat, potatoes. All of that stuff then has to be transported somehow from the farms to the processing plants, and then to the thousands of stores around the country (and the world).
One might ask why the actual manufacturers of the goods aren't included in the index. Why use McDonalds? It's a global conglomerate The reason is that the company itself is responding directly to the drive of both the supply and demand. They create the products that require supply, and their customers buy the products which then creates (and fulfills) demand. This happens on such a massive scale that a lot of resources are needed in order to make it work. So McDonalds, in essence, creates industry on a massive scale.
Out of the slew of companies that create and deliver, some of them more fundamentally reflect the supply/demand picture of the economy than others. These are the companies which are included in the Dow transportation and industrial averages. In the 1900s, most of the economic activity in the US was centered on manufacturing of industrial "hard" goods that were central to the economic life of the country: car manufacturing, smelting and refining, lumber processing, steel making, rubber making, and sugar refining. This is what we might now call the basics, and were incredibly vital money-producing components of the economy. If these companies weren't profitable, or lagged their transportation counterparts, it indicated looming economic trouble because this meant that inventories weren't being replenished by manufacturers.
On the other hand, when these companies were profitable, it indicated solid economic conditions if companies on the demand side (in the transportation average) were confirming the profitable trends. Today, the same holds true, and as I will argue, the averages reflect the change in economic context well, holding to the supply/demand relationship that the two averages are suppose to paint a clear picture of. The thing that is making the averages hard to predict is the onset of high frequency trading. One must look to the weekly closing prices of the averages in order to get the clearest indication of where the economy stands, rather than the daily closing prices as was the case in the 1920s.
Times Have Changed ... Haven't They?
Yes. Times have changed. The US economy is a massively complex beast. The trick is to identify companies which are sensitive to the supply and demand sides of the economy as is now ... not 'as was' back in the 20s, 30s or even 90s and early 2000s for that matter!For example, even though Walt Disney is technically a consumer discretionary company, it is included in the Dow 30 because Walt Disney is a producer of an important industrial good: Disney itself. Case in point: Why watch the Disney channel? It's because Disney produces what has become an industrial commodity: Television shows. Why is a television show an industrial commodity? For no other reason than the fact that it is distributed en mass. Anything that is distributed en mass is, in reality, an industrial commodity. But to fully answer this question, or even understand the assertion that something non-industrial is in fact industrial, we need to look beneath the final product into all of the components which make up that product.
Think about the millions of technological and industrial components needed in order to create and broadcast a single television show. You need cameras, which are made of plastic, metal, glass and chemicals; sets which include literally everything in your house (and more); food for actors, computers for the swath of editors; headsets, microphones, cars, special effects equipment ... the list goes on and on. All of these things need to be manufactured and delivered. Then you need Televisions and the thousands of components that go into them. Televisions are created in insane quantities to meet the demand that people have to not only watch shows, but to view them in high quality. Disney is thus a good representation for the supply side of the economy, because they are meeting a consumer demand for entertainment products of a huge variety. And now that Disney owns lucasfilm, this scope got a lot larger. Diney is perfect for the Dow.
Or how about Disney dolls? You need to manufacture liquid plastic; cloth and paint; and you need to create chemical compounds just to name a few of the basic materials. You also need to create cast iron moldings to cast the doll's shape. If it were only one doll, there would not be much industry needed to complete the proceeds, but if there are hundreds of millions of dolls to create, then an entire industrial complex needs to be set up in order to facilitate the business.
There are companies which both create and distribute better or in larger quantities than others. And there are some companies that distribute and/or create these new industrial products with such volume, that they have become precipitously central to the economic vitality of the US. In effect, the rise of the American consumer created a whole new subset of industry in which literally everything and anything could become an industry if the products being created were desired badly enough by enough people.
In summary, all economies consist of companies who make things, and companies that deliver them.
Demand - The Transportation side of Dow's Theory
Certain companies are sensitive to the economic cycles of transportation industries and the "demand" end of the economy, like Airline booking companies, trucking companies, rail companies, airlines themselves, and parcel delivery companies. As we have seen, other companies are sensitive to the supply side of the economy; companies like Boeing, which makes airplanes, or companies like Microsoft, which create software. Microsoft is interesting, because they are primarily a software company. We might see them as not appropriate for the Dow, but in reality, a lot of manufacturing goes into software design: the computers needed to create, the chemicals and elements needed to manufacture the discs and boxes, and now the components needed to manufacture the new microsoft tablets. Microsoft is a fundamental driver for PC computer manufacturing. They are more fundamental than the individual manufactures of a PC's individual components. That's why Microsoft is the Dow 30, and not ASUS.A lot of people don't seem to get that even though our economy is no longer traditionally industrial (its rather consumer-oriented and product-oriented), the companies which make up the averages still represent the two fundamental and correlated (supply/demand) sides of the economy. Its just that our economy is particularly on crack, as we've made everything into an industry. Thus, one could conclude that our economy is in fact more industrial than ever, because we own the companies that use industrial processes to create stuff at an ever increasing rate.
Thus, any US based company that is responsible for creating products that are sold in the US en mass should be considered industrial, and any company that delivers stuff of any sort can and should be considered a transportation company. Until our economy stops reflecting the industrial mind set (i.e. when we stop having a music industry, health care industry, and a drug industry etc) the truth of Charles Dow's theory will hold.
A final example: Why would American Express be included in the Dow 30 industrial average? They certainly don't produce anything traditionally "industrial", and I'm sure any hard goods they do make is manufactured in China. On a physical level, Amex makes plastic cards and advertisements. But on a theoretical level, Amex industrially produces CREDIT, which is (ironically) the most fundamental industry in the West. Without credit, our economy is finished.
Think about it.
Ryan
