Is Dow Theory signaling a market downturn?

The venerable Dow Theory may be signaling a warning — but the signal has a great deal of noise.

Dow Theory is named after Charles Dow, co-founder of Dow Jones & Co. and the Wall Street Journal. Dow created the Dow Jones industrial average by adding up the prices of 12 large publicly traded stocks and dividing by 12. (Times were simpler back then).

The Dow Jones industrial average made its debut on May 26, 1896, when Grover Cleveland was president and Model T was just a twinkle in Henry Ford’s eye.

Later, in a series of 255 essays, Mr. Dow laid out the essentials of Dow Theory. One major tenet: New highs by the Dow Jones industrial average must be confirmed by new highs in the Dow Jones transportation average. Presumably, increases in industrial production would be accompanied by increases in transportation of goods to and from factories.

Dow Theory’s latest bull market signal was in October, prior to the election, when both the industrials and transports hit new highs, says Charles Carlson, co-editor of Dow Theory Forecasts, a newsletter.

While the signal still stands, “There’s a bit of a fly in the ointment,” says Mr. Carlson. “Neither index has eclipsed their March 1 highs, which would be a re-confirmation of the bullish trend.”

Most worrisome is the behavior of the transports. Since then the Dow industrials are down 0.72%. while the Dow transports have fallen 6.38%. “Most people don’t pay attention to the transports, but we do, because it’s extremely economically sensitive. We’d like to see the transports behave better.”

Dow Theory certainly isn’t infallible. “When monitoring the rolling 90 trading-day correlation between the DJT and the DJIA over the past 20 years, while most market declines of 10% or more were indeed preceded or accompanied by divergences of at least two standard deviations below the mean, not all divergences of that magnitude resulted in severe declines,” wrote Sam Stovall, chief investment strategist for CFRA, in a recent client letter.

So how seriously should you take the Dow Theory weakness? “We believe that investors should not ignore its warning that a pullback (decline of 5%-9.9%) or even a correction (-10% to -19.9%) is possible,” Mr. Stovall wrote. “The length of time since the last correction is a simple supporter of that conclusion.”

But he’s not terribly worried. “We still believe that this bull market has further to run. Bulls don’t die of old age, they die of fright. And they are most afraid of recessions, which we don’t see on the horizon.”