By Deepa Seetharaman - Analysis
NEW YORK (Reuters) - As criticism mounts to make over the Dow Jones Industrial Average, the godfather of one of the oldest stock forecasting methods known as Dow Theory sees few pressing reasons for upending its lineup.
Debate about how well the Dow industrials reflect the broader economy, and therefore the worth of Dow Theory, has swelled in recent months. Critics argue that an overhaul of the price-weighted index is needed now that five of the Dow’s 30 components are trading well below $10.
But Richard Russell, editor of the famed Dow Theory letters, said the blue-chip index’s recent plunge past lows set in November serves as evidence that the index, even with the inclusion of battered stocks, is still capable of signaling market trends.
Dow Theory aims to identify the primary trends in stock markets, lasting from one year to several years. It stipulates that the industrials index must “confirm” a high or a low in the Dow Jones Transportation Average .DJT for a trend to last.
According to Dow Theory, the Dow’s value as a barometer of market trends was borne out just this week because the industrials dropped nearly one month after the transportation index shattered its November low, suggesting future market losses.
“The fact is those same stocks were in the average on November 20th and here we are below the November low,” Russell said in an interview. “And they didn’t pull the stocks under $10 from the average.”
Russell has done more than anyone to popularize Dow Theory, the analytic system developed in the late 1890s by Charles Dow, founder of The Wall Street Journal, which is published by Dow Jones & Co. The company, part of Rupert Murdoch’s News Corp (NWSA.O) ,also owns and maintains the blue-chip Dow average.
In November 2007, a trough in both the Dow industrials and the transportation index signaled a looming bear market one month after the Dow and S&P 500 scaled record highs. Since those highs, both indexes have halved.
Still, Dow Theory has its limits. One is its underlying belief that the Dow contains major market movers, a notion that has been hotly debated for decades. The continued Dow membership of battered stocks including Citigroup (C.N) and General Motors (GM.N) have reignited the debate.
“Institutional investors just don’t see it as a reflection of the market,” said Fred Dickson, market strategist for D.A. Davidson & Co.
Dickson said investors “don’t pay any attention to the Dow Theory because of the massive changes in the Dow over time and the Dow includes stocks that are no longer representative of the leaders.”
On the other side of the debate are those who say the Dow is still a good barometer of troubles in the economy.
The Dow “for all its faults, is a sentiment indicator and you can see that things just feel bad,” said Warren West, principal at Greentree Brokerage Services.
Russell himself has at times been one of the Dow’s doubters. In an interview last week he said that without adequate representation of the financials, the Dow may take longer to confirm a bear market signal.
But he changed his mind days later when the Dow plunged to a 12-year low, followed closely by the S&P 500’s tumble below its 12-year closing low.
“The reconfirmation came quicker than I thought it would,” Russell said. “As far as the Dow Theory goes, the relationship still holds.”
Editing by Leslie Adler