Does the Dow Truly Reflect the Industrial Outlook?

The Dow Jones Co. shocked the financial world last week when it announced it was de-listing four of the 30 components that make up the famous Dow Jones Industrial Average. In place of these four "old economy" stocks, four "New Economy" stocks have been added.

Analysts were stunned when it was announced that stalwarts Goodyear Tire and Rubber Co., Union Carbide, Sears, Roebuck and Co. and Chevron Corp. were being dumped in favor of younger service-oriented stocks primarily in the technology sector. Two of the new additions, Microsoft and Intel, are NASDAQ stocks—the first time a non-NYSE-listed stock has ever made it into the venerable Dow index. The other two—Home Depot and SBC Communications—are consumer-oriented stocks.

The recent shake-up was the cause of much debate among Wall Street analysts and news commentators as to how much the Dow Jones truly reflects the state of industry in America. Even before the entries of the tech-era stocks, some observers were already asking this question, as less than half of the Dow's 30 components can truly be considered "industrial" stocks. Today's Dow instead seems to be an amalgam of high-tech, consumer, retail and various other service-sector companies that are not directly involved with industrial manufacturing.

Interestingly, most experts do not question this service-biased make-up of the Dow. Most seem to have bought the "New Economy" argument, which asserts that industrial "bricks and mortar" manufacturing no longer offers value in a country with a vast service economy such as ours. Instead, the collective eyes of the investing public seem focused on Internet stocks and other high-flying securities of service-based companies. But is this investment philosophy valid?

It has always been our belief that a strong industrial sector is essential to a strong economic outlook. Regardless of how broad of a service sector exists in America, without industrial manufacturing, a service economy would cease to exist. That's because services—as the name "service" implies—is a concomitant to industry, and without industry the service economy would have nothing to "serve." An apt analogy would be a nation full of auto mechanics (services) where there are no cars (industry) to work on. The mechanics would then all be thrown out of work.

While there may indeed be relatively little industrial manufacturing taking place in America today, that does not obscure the fact that America still leads the world in industry. Most of the leading domestic and global companies are American-based, though the actual manufacturing is often done over-seas in Third World countries where the labor is cheaper and the environmental and corporate tax laws are less stringent. The bottom line is, America still leads the world in industrial manufacturing, and if anything were to happen to upset that balance the service sector, and by extension, the world economy, would come falling down.

Thus, it behooves us to obtain an accurate picture of where the industrial outlook may be headed. To that end, we have constructed what we to believe a far more reliable indicator of industrial activity than that of the Dow Jones "Industrial" Average. We will call it the "Leading Indicators Industrial Average." It is composed using a charting technique known as the "Wyckoff Wave Method," which averages five of the leading stock in a given sector or industry. [We dedicate a chapter to this imminently useful analytical tool in our most recent book, Elliott Wave Simplified]. Each component is given equal weighting, meaning that it is a simple average. In this case, we decided to average the five leading industrial stocks in the U.S. (all of which are listed on the NYSE). The selection process in itself was not without considerable difficulty. After all, how does one determine which stocks to include and which to reject? Ultimately, we decided to use as our criteria the principle that each stock should be reflective of a "core" area of industrial manufacturing. Each one of these five stocks represent five basic areas of industry that are absolutely essential for the continuation of manufacturing in general, as well as for the health of our financial system and economy. They are as follows: Bethlehem Steel, General Motors, DuPont, Exxon, IBM.

While we do not wish to be prolix in explaining our reasons for selecting each of the above-named component stocks, we will at least provide a brief synopsis: Bethlehem Steel is perhaps the most actively traded, U.S.-based steel stock. Steel is the backbone of industrial manufacturing, since without it buildings, machinery, and automobiles (the bedrocks of our physical economy) would be impossible. General Motors because it represents perhaps the biggest and most actively-traded stocks of the auto industry ("What's good for GM is good for America," as the old adage goes). DuPont because it represents both domestic and global chemical manufacturing. Everything from the paint on your walls, to the rubber in your shoes, to the health care products in your bathroom, to the food on your plate most likely involves one of DuPont's chemicals or chemical processes. Exxon because it represents the multi-national oil and petrochemical industry. Unlike most oil stocks, Exxon is not adversely influenced by low oil prices since it encompasses a wide area of production, everything from oil drilling, shipping and refining, to natural gas cracking, and various other petro-chemical processes. Finally, we decided to include IBM because, while not a strict industrial stock in the true sense of the word, they are nonetheless involved in a form of manufacturing and they service the entire business community both here and around the world with their computers and business machines. IBM is to a large degree the "electronic brain" of the world economy.

When we averaged the daily high, low and closing prices, along with daily volume, of these five stocks we were surprised and pleased with the result. It seems that the "Wyckoff Wave" form of charting captures the essence of a given stock market sector due in part to its simplicity. Unlike other methods for constructing stock indexes, it doesn't involve complex weighting formulas and arbitrary methods of selection. And as esoteric as this may sound, the number five seems to have a tremendous significance in the realm of technical analysis (as any Elliott Wave analyst would know); hence the use of five stocks in the average.

So what does our "wave" chart tell us regarding the industrial outlook? The first thing we noticed was how much smoother and less volatile this chart was compared to the Dow. Gone were the violent whipsaws and fluctuations that characterized trading during the summer and early autumn months of this year. Instead, the wave chart of the five industrial stocks gives us a nice, linear slope that is easy to interpret and is very conducive for trendline analysis. Even more impressively, the corresponding volume bar chart below the price bars are much easier to read in conjunction with the price bars, as opposed to the Dow Jones index, which makes reliable volume analysis almost impossible due to the unequal weighting of the components and the wild fluctuations.

This new industrial average proved indispensable for isolating the recent bottom of the autumn decline in blue chip stocks. IBM, in particular, was the cause of much speculation among analysts after it dropped over 20 points on record volume in October. This had the effect of producing a huge gap on IBM's chart, which made interpretation extremely difficult due to the unpredictable nature of gaps. When IBM was factored into our industrial average, however, the implication seemed clear: the day of IBM's big decline produced on our wave chart a "key reversal" day wherein prices close at or near the high point for the day on extremely high volume. This almost always signifies that at least a temporary bottom is in place. This was part of our basis for calling the recent decline in stocks over for now, as mentioned in our Nov. 1 Gold-Eagle article.

But the outlook for industrial stocks as measured by our indicator is not completely bullish yet. As can be seen in the chart we produced, the downtrending resistance line extending from August has not yet been penetrated. As we write this, prices were testing resistance and were looking to clear the trendline but it had not happened as of this writing. This will likely occur within the next few days. If it does not, we will have received an early warning that all is not well within the industrial sector.

Our overall experience with wave charting has been very positive. It has allowed us to make some impressive technical calls due to the prescience they seem to exhibit. They simplify the trend in most stock sectors, thereby making it easier for the analyst to follow. Most importantly, it is free from the complications and biases of modern index weighting systems that has only recently come to light in the case of the Dow. In conclusion, we highly commend this form of technical analysis. We will continue to apprise you of the message that this new (and presumably reliable) indicator gives us.