(Bloomberg View) -- The Dow Theory was one of the first attempts to decode stock market price signals and make them useful to traders and investors.
The idea is straightforward: Stock price trends should show logical and fundamental consistency across industries. Volume confirms price. And, most important, equity prices move in long-term patterns. More than 100 years after the theory was developed by Charles H. Dow, traders still adhere to its basic tenets.
These time-proven rules can be adapted to a new problem: how to track the market’s worry over the possibility of a global trade war. After decades of increasing globalization, investors do not have much of a map for this journey.
But by merging the Dow Theory with the Dow Jones Industrial Average, Charles Dow’s other notable creation, investors can quantify market sentiment about changes in global trade structure and track how it shifts over time. Despite its advanced age, the Dow does have unique features that make it fit for this purpose:
- With a 17 percent weighting in technology, it more closely resembles typical global equity exposure to this sector than the S&P 500, which has a 24 percent technology weighting.
- The Dow’s technology names (Apple, IBM, Visa, Microsoft and Intel) avoid the worst of the current worry about the potential regulation of data privacy.
- Every company in the index employs a global supply chain and often has a worldwide sales footprint as well. And because there are only 30 stocks in the Dow, it is easier to evaluate investor confidence in such far-flung business models than in any other widely-followed index.
So what does “Dow Theory meets Dow Jones Industrial Average” tell us about the current intersection of U.S. equity markets and global trade negotiations?
- The trend is not positive. Investor concerns about global trade inform market direction more than even the technology sector’s recent woes. As of the Thursday’s close, the Dow was down 1 percent for the year. The S&P 500 was off less, only 0.4 percent. Large-cap tech stocks are actually up a respectable 4.1 percent for the year-to-date. Trade really does trump every other headline.
- Looking at individual companies in the Dow that are uniquely leveraged to globalization, we see strong year-to-date price correlations. Like the transports of Dow Theory, they are leading indicators of investor confidence in international trade.
Consider that all the Dow’s losses for the year through Thursday came from just two names: 3M (126 points) and Home Depot (108 points). Proctor & Gamble (89 points), Walmart (86 points), and McDonald’s (75 points) have also put outsized pressure on the index in 2018.
So far, Boeing has been surprisingly immune to trade concerns. The stock is up 14.4 percent for 2018, adding 332 points to the Dow. With a weighting of 9.3 percent, it is the index’s single more important constituent.
- The fact that one theoretic trade war target -- Boeing -- actually supports the Dow while five other stocks drag it lower shows the nuances of this new trade-monitoring version of Dow Theory.
Here are a few additional points to bear in mind:
- Boeing may be a high-value target in a trade war, but it also operates in a stable global oligopoly where product lead times are very long. Yes, international carriers may start cancelling orders if trade negotiations take a turn for the worse. This does leave airlines with a problem, however: How do they fill the gaps in their fleets until other aircraft manufacturers can complete their orders?
- The names that have pulled the Dow lower (3M, Home Depot, McDonald’s, Proctor & Gamble and Walmart) are those that worry investors most in terms of the collateral damage of a trade dispute. These five names have a collective 20.4 percent weighting in the index.
Walmart and Home Depot built their businesses to leverage low-cost Chinese manufacturing and deliver low prices to U.S. consumers. Proctor & Gamble, McDonald’s and 3M all generate more than half their revenue outside the U.S., versus 31 percent international exposure for the typical S&P 500 company.
- GE, Coca-Cola and DowDuPont have also underperformed this year, but their weightings in the Dow are small (0.4 percent, 1.3 percent and 1.8 percent, respectively).
The Dow is telling us that we’re not out of the woods yet. The stocks mentioned above, which are highly exposed to trade, are all still under pressure. Boeing’s contribution to the index -- an artifice of its high stock price -- masks this weakness. But Dow Theory reminds us to always look at leading indicators. And those signal more volatility ahead.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Nicholas Colas is the cofounder of DataTrek Research. He is the former chief market strategist at Convergex Group LLC.
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