If you ever have heard or seen “transports” mentioned in market commentary, you have been exposed to Dow Theory. Dow Theory is a concept developed by Charles Dow (the “Dow” in “Dow Jones”) that is frequently referred to, but often not explained.
Dow Theory uses the movement of the Dow Jones industrial average and the Dow Jones transportation average to determine where the market may be headed. It uses two averages instead of one to provide what is known as “confirmation.” Dow Theory requires both Dow Jones averages to show similar moves; if the movement of one average is unlike that of the other, no signal is given. Jack Schannep, editor of TheDowTheory.com newsletter, explains Dow Theory in greater detail starting here.
Confirmation is an important concept in investing. Regardless of whether you use fundamental analysis, technical analysis or both, you want a variety of indicators to give you positive signals before buying. Any signal indicator can mislead you. A low price-to-book ratio may make a stock seem cheap, but if earnings are falling, the stock is no bargain. Similarly, if the Dow Jones industrial average is trending upward, but the transport average is simply muddling along, the charts may not be in your favor.
With large-cap stocks, combining fundamental and technical signals can be particularly useful. A stock with a low valuation, rising earnings and an upward price trend is likely to make you money. The rationale is simple—strong fundamentals provide a reason for the stock to rise and, because everyone likes a winner, upward momentum attracts buyers. Nothing is ever guaranteed on Wall Street, however, so realize that signals are just signals, rather than flawless predictors of where the market is headed.
From the standpoint of valuation, Morningstar’s Christine Benz says opportunities to buy stocks currently exist. To find them, investors should be willing to roll up their sleeves and seek out value-oriented stocks or funds. Christine, a frequent speaker at local AAII chapter meetings, advises factoring in company-specific issues and the ability of a company to fend off competitors (what Morningstar refers to as a “moat”). She explains further here.
The middle ground between technical analysis and fundamental analysis is to use both. For example, Investor’s Business Daily (here.focuses on strong growth in sales and earnings to identify potential “new edge” stocks. Technical analysis is then overlaid to spot buying and selling signals. Christina Wise of IBD provides examples
John Bajkowski used the fundamental criteria listed in Wise’s articles to screen for stocks. His First Cut column can be found exclusively on our website at www.aaii.com/new-edge-stocks.
Joe Lan shows you 16 financial ratios that reveal a company’s merits and weaknesses. The advantage of using ratios is that they make comparisons between companies easier. This latest installment of Joe’s series on financial statement analysis begins here.
I realize that, for many of you, investment income is a concern. This is why I reached out to Jason Brady, a portfolio manager with Thornburg Investment Management and author of “Income Investing” (McGraw-Hill, 2012), to discuss choosing between bonds and stocks. Jason says the choice depends on the individual merits of an investment, as you will see here.
For the second consecutive year, we are publishing a listing of the exchange-traded funds with the best three-year total returns. Real estate ETFs took the top five spots, though their performance was aided by a combination of the calendar and falling interest rates. The list appears here.
Speaking of top-performing funds, I sat down with Brian Peery. Brian co-manages the Hennessy Focus 30 fund (HFTFX), one of the top-performing mid-cap stock mutual funds for the past three years. Brian discusses how he uses quantitative analysis (e.g., stock screens) to identify stocks and limit subjective influences here.
Wishing you prosperity,
Charles Rotblut, CFA
Editor, AAII Journal