Posted on March 14, 2007 at 20:15 PM EDT

In an article dated November 1, 2006, titled The True Market Bellwethers, I detailed a method for identifying favorable market periods based on the action of what I consider to be, well, the true market bellwethers - the Dow Jones Transportation Average (DJTA) and the Dow Jones Utilities Average (DJUA). This method, which I refer to rather long-windedly as the Utility/Transport Bellwether System (or UTBS for short) is calculated as shown below:

DJIA = Dow Jones Industrial Average
DJUA = Dow Jones Utility Average
DJTA = Dow Jones Transportation Average

A = Percentage change for DJUA over past 100 trading days
B = Percentage change for DJTA over past 100 trading days
C = Percentage change for DJIA over past 100 trading days

D = (A - C)
E = (B - C)

In a nutshell, Variable D is positive if the Dow Utilities have outperformed the Dow Industrial over the past 100 trading days. Variable E is positive if the Dow Transports have outperformed the Dow Industrial over the past 100 trading days. As it just so happens a positive reading for Variable D or Variable E is a positive sign for the stock market. And as we will see in a moment, when both Variable D and Variable E are positive it is a very favorable sign for the stock market.

For the purposes of this model, if both D and E are positive then the UTBS reads +2. If only D or E is positive then the UTBS reads +1. If neither D nor E is positive then the UTBS reads 0. Let's take a look at why this matters.

Chart 1 displays the growth of \$1,000 invested in The Dow Industrials since June 1986 only when the UTBS is greater than 0.

Chart 1: Growth of \$1,000 in DJIA since June 1986 when UTBS is > 0

Chart 2 displays the growth of \$1,000 invested in The Dow Industrials since June 1986 only when the UTBS is equal to 0

Chart 2: Growth of \$1,000 in DJIA since June 1986 when UTBS is = 0

The difference in the results that appear in Charts 1 and 2 is quite striking. To put some numbers to these results, consider the following:

• Investing in the Dow Industrials when the UTBS is greater than 0 saw \$1,000 grow to \$9,141 (this does not include any interest earned while out of the market).
• Investing in the Dow Industrials when the UTBS is equal to 0 saw \$1,000 shrink to just \$710.

So this represents a difference a gain of +814.1% versus a loss of 29%. This kind of gap is what we numbers geeks refer to as statistically significant.

Now let's consider one other fact that I did not highlight in the original article: on an average daily return basis, the market is twice as strong when the UTBS registers a reading of +2 as when it registers a reading of +1. Chart 3 displays the growth of \$1,000 invested in the Dow Industrials only when the UTBS registers a reading of +2 (i.e., when both the Dow Transports and the Dow Utilities have outperformed the Dow Industrial over the previous 100 trading days).

Chart 3: Growth of \$1,000 in DJIA since June 1986 when UTBS is = +2

As you can see in Chart 3, when the UTBS registers a reading of +2, serious market declines are quite rare. The good news now is that the UTBS flipped to a bullish +2 reading at the close on 3/2/07. So let's look at a simple way to maximize profitability using the UTBS Method.

Here are the rules:

• If the UTBS is reading +2, then we buy and hold the Dow Industrials using leverage of 2-to-1. This can be accomplished using the Proshares UltraDow 30 exchange-traded fund (ticker symbol DDM).
• If the UTBS is reading +1, we buy and hold the Dow Industrials without using any leverage. This can be accomplished using Dow Diamonds (ticker symbol DIA).
• If the UTBS is reading 0, then we simply hold cash. For the purposes of the following test, we will assume a nominal rate of interest of 1% per year.

So how did this method perform?  Chart 4 displays the growth of \$1,000 using the rules we have just detailed above. The purple line represents the growth in equity using this strategy. The blue line represents the growth in equity using a buy-and-hold approach.

Chart 4: Growth of \$1,000 in DJIA since June 1986 using trading rules (purple line) versus a buy-and-hold approach (blue line)

For the record:

• Investing in the Dow Industrials using the trading rules I described would have grown to \$26,747.
• Investing in the Dow Industrials using a buy-and-hold approach would have grown to \$6,487.

These numbers exclude taxes, commissions and dividends. Still, the gap between the system results and the buy-and-hold approach are compelling.

SUMMARY

From the results of the tests above it would seem quite fair to say that leadership matters.  If at least one of the market bellwethers is outperforming the industrials, that is a good sign. And if both bellwethers are outperforming the Dow Industrials, that is a great sign. One cautionary note, however: does any of this mean that the stock market is sure to advance this time around?  Ah, there's the rub. Sometimes historical trends follow through and alas, sometimes they don't. The best that we can do is to put the odds on our side to the greatest degree possible and hope for the best.

The market will tell us how it feels about our decisions in its own good time.

Jay Kaeppel
Optionetics.com ~ Your Options Education Site

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