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Forget Dow Theory: Small Caps May Be a Better Market Indicator

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The Dow Transportation index hitting a record high Thursday is seen as a bullish sign for equities, but some strategists say the upward trajectory in another index may be a more meaningful gauge for the market and economy.

"It's nice to see transports at an all-time high, but we're more impressed with the action in small caps these days," said Ryan Detrick, senior technical strategist at Schaeffer's Investment Research. "The Dow Theory isn't as important as it once was because the U.S. has shifted to a services-based economy."



According to the Dow Theory, which was developed more than a century ago, the Dow Jones Industrial Average and the Dow Jones Transportation index move in lockstep to reach new highs or lows. But if they diverge and one index does not confirm the other, the market is expected to go back to its former trading range. Dow theorists often disagree on when a true breakout has occurred, and traders say they risk missing out on a major move while waiting for their signals. (Read More: 10 Stocks Send Transports Surging)

The Dow Transportation index has surged to its historic high after a more than 15 percent move in the last two months, mostly on gains in airline stocks. Meanwhile, the Russell 2000 index and the midcaps also reached historic highs, but on a much broader mix of industries. (Read More: S&P 500 Ends at 5-Year High)

So if the theory were to work out, the Dow Jones Industrials would now see a four percent rally in the near-term to match the Dow Transport index's all-time high. The Dow Jones hit its all-time high of 14,164.53 back in October 2007. The index has already gained four percent in January alone, extending its seven percent rally in 2012. (Watch: Could Dow Drop 20%?)

"Small caps are more domestic by nature and act as a better indicator for the economy and market," explained Detrick. "They started outperforming in November when the rest of the market was worried over the 'fiscal cliff.' Small caps almost foreshadowed the rally, in our opinion."

Still, some strategists dismissed the idea that the Dow Theory may be outdated, saying the concept is more important than ever.

"The Dow Theory fell apart since the Internet era and may not be in vogue, but it's still a very important and underused economic signal—one thing that's impossible to hide is economy activity from transportation stocks," said Art Hogan, managing director at Lazard Capital Markets. "We're seeing more and more consumer transactions online and those goods are being delivered—by transports!"

  • Patti Domm

    Patti Domm is CNBC Executive Editor, News, responsible for news coverage of the markets and economy.

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