Ben7's blog

Dow Theory Buy Signal Confirms This Sector Is Hot
By Nicholas Ward

One of the six tenets of the Dow Theory is that indices must confirm each other. Charles Dow broke the market down into two indices: the Dow Jones Industrial Average and the Dow Jones Transportation Average. Accordingly, for a trend in the markets to remain intact, both major averages must be moving in the same direction.

As I'll explain, the Dow Theory is now flashing a green light to invest in banks.

The reason that Mr. Dow broke down the market into industrials and transports is due to this basic philosophy:

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If the business is strong, profits will be rising. And, if profits are rising, manufacturing should increase to meet the sales demand. If production is up, then there will be more goods to ship to consumers.

This is why Mr. Dow looked to the transports to validate the industrial trends. He saw transports as a bellwether and most analysts still do.

Now granted, America has changed quite a bit since Mr. Dow was alive in the latter half of the 19th century. His theory was based upon the economics that arose from the Industrial Revolution. However, the general principles of his work still apply today which is why market analysts continue to use his theories to spot trends.

The Dow Jones Industrial Average hit new all-time highs in late September. Although some analysts like to talk about narrow leadership in the markets, when I look over the Dow components, I see a lot of strong companies doing very well.

The Dow Jones Transports Average is trading similarly well. The rails are trading at all-time highs. Boeing (NYSE: BA) is reaching new highs in the aerospace industry.

To be sure, the major logistics players, FedEx (NYSE: FDX) and United Parcel Service(NYSE: UPS), have struggled a bit in 2018 after hitting peaks during January's exuberance. However, when you take a step back and look at their long-term charts, they've performed exceedingly well in recent years. Rising fuel costs have put a bit of a damper on the airlines, but overall, this index is sitting at near all-time highs, too.

Money in the Bank

This is what has led me to the banks. When you look at the Dow 30, it's clear that the financial components within the index are the major underperformers. To me, this doesn't make sense. I understand that the financials suffered mightily during the Great Recession and many investors are still wary of these names. However, if the broader economy is as strong as the Dow Theory seems to suggest, investors shouldn't be overly cautious regarding this sector.

Actually, you'd think it would be the other way around. A strong economy should result in consumer spending, loan growth, and rising interest rates. All of these trends are great for banks. 

The fundamentals of the big banks have been improving. For the most part, sales and profits are trending upwards. Management within the industry is returning massive amounts of excess cash to shareholders. The combination of increased dividends and stagnating share prices have led to dividend yields above the 5-year averages of many of the well-known money center banks. Buyback authorizations in this space are in the billions as well, which should help profitability metrics continue to grow down the road.   

I won't sit here and attempt to make bold macro calls on the market. To me, that's a fool's errand. It's important to note that when we hit a recession again (and it's only a matter of time before we do) it's likely that the banks will perform badly and their dividends could possibly be put at risk. But the same thing could be said about myriad other stocks in the market. Generally, I'm happy to own a well-diversified mix of stocks because I don't have any idea when or where the next market crash will occur. 

Market crashes usually arise from black swan events. If you believe in efficient markets, any catalyst of a major change in sentiment has to be unpredictable. Otherwise, it would be discounted and wouldn't lead to volatility. However, as an income-oriented investor looking for value in the markets, it's difficult for me to ignore the banks. 

So, if you're looking for passive income, you like buying low rather than high, you believe in the strength of the U.S. economy and don't see a recession on the horizon in the short-term, and you've got a little bit of a contrarian in you, then maybe it's time to ignore some of the popular trades in the market and take a closer look at the banks. The Dow Theory reads "go.”

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