What can a 110-year-old indicator tell us about the stock market? Quite a bit, if recent headlines are any indication.

We’re talking about Dow Theory, which emerged from a series of Wall Street Journal editorials written by Charles Dow in the late 1800s. There are several components to the theory, but the one that has received the most attention recently is the need for a new high in the Dow Jones Transportation Index to a confirm a new high in the Dow Jones Industrial Average. While this can be an important indicator, any discussion of transports’ recent shortfall needs to be taken with several grains of salt.

Here’s why: Almost all of the underperformance registered by transports occurred in February. Since then, the sector has held up well relative to the broader market. The table below shows the month-by-month performance of the iShares Dow Jones Transportation Average Index Fund (NYSE:IYT) versus the SPDR Dow Jones Industrial Average ETF (NYSE:DIA).

Click to Enlarge The relationship is reflected in chart form here. A rising line indicates outperformance for transports versus the Dow, while a falling line indicates underperformance.

This demonstrates the need for investors to be sure they know exactly what time period is being discussed when there is any talk of “lagging transports,” since the majority of the underperformance is limited to a single three-week period.

Potential Fallacies in Dow Theory Reporting

There are two other ways in which discussions about the DJIA-DJT relationship can lead investors astray.

First is the use of the Dow Jones Industrial Average itself. The original thinking behind Dow Theory is that industrials “make” while the transports “take.” As a result, one index needs to confirm a move in the other to show that the economy is truly clicking on all cylinders. But the problem now, of course, is that more than 78% of the DJIA is made up of non-industrial companies. Further, IBM (NYSE:IBM) has an outsized impact on any divergence between the two since it makes up nearly 12% of the price-weighted DJIA.

Click to Enlarge Second, the conventional wisdom holds that higher oil prices should be a negative for transports by leading to higher costs. However, the conventional wisdom might be flawed. The three-year chart shows that the returns of oil and transports actually are correlated — probably because of the impact of central bank liquidity injections across all markets — and that IYT has managed to gain 70%-plus in the past three years, even with the price of oil up nearly 35%. In addition, the transports held up well even as oil was spiking in 2008. Keep this in mind when rising energy costs are cited as the leading cause of transports’ year-to-date underperformance.

The Impact of Beta

Click to Enlarge Perhaps the most important consideration in assessing transports’ relative performance is that the sector tends to be a higher-beta play than the rest of the market. As this chart demonstrates, IYT tends to outperform the Dow in rising markets and underperform in falling markets. This, more than anything, appears to be the driving force behind any performance gap in the modern era.

A Look Inside IYT

The table below shows the components of IYT along with their year-to-date returns, which helps provide a sense of what stocks have been driving the ETF’s performance so far in 2012. DIA is up 6.55% year-to-date, while IYT has gained 4.43%.

As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.