Modern capitalism is well represented in the Dow Jones Industrial Average, which tracks 30 of the highest capitalized and best-known American corporations. It serves multiple purposes, from the headline number on the evening news to a speculative instrument trading through mutual funds, SPDR Dow Jones Industrial Average ETF (DIA) and CBOT Dow e-Mini futures contract.
Many traders and institutions focus on Dow component performance to predict broader index action and direction. The 30 components often trade in closed systems in which capital coming out of one member finds its way into another member. Hedge funds executing intra-index basket strategies and traditional index mutual funds add to this tendency.
The Industrial Average uses a price-weighting methodology, in which more expensive components carry a higher relative weighting.This calculation can skew price action, especially when volatility spikes to high levels on the largest components. Conversely, high volatility in the smallest components has a diminished impact on index pricing, especially when matched with low volatility at the other end of the price spectrum.
Money Flow Analysis
Tracking Dow money flow allows observant market players to identify the handful of components most likely to produce profits within their time frames of interest. Rotational themes tend to persist for months at a time, supporting both short-term trades and long-term investments. Subsets of these components can also be bought and sold in highly liquid baskets, based on rotational characteristics.
Analyze money flow through the filters of price, capitalization, and relative strength. Start with a spreadsheet of the 30 companies or use the database function on more sophisticated charting software programs to create a watch list. Set the three categories as columns and sort each column in turn to find the strongest and weakest components.
The price column tracks the Dow’s weighting methodology, with the highest weighted components rising to the top while the lowest sit on the bottom. Price impacts capitalization but outstanding shares are equally important and the relationship should change slowly over time, making comparisons easier.
Pay close attention to capitalization levels, committing as many of those numbers to memory as possible, because rapid rise points to components under institutional accumulation. While these changes often show up in technical measurements, pricing can miss the impact of stock buybacks, dividends, and acquisitions that can add substantially to valuation.
Relative Strength Calculation
The relative strength column displays a value that compares current price to the 200-day EMA and then calculates the percentage above or below the moving average:
(( Price - 200-day EMA ) / 200-day EMA ) * 100 = Relative Strength
EXAMPLE 1: Exxon-Mobil (XOM) 200-day EMA sits at 82 while the stock trades at 76:
(( 76 – 82 ) / 82 ) * 100 = -7.31% or 7.31% BELOW the 200-day EMA.
EXAMPLE 2: Nike (NKE) 200-day EMA sits at 114 while the stock trades at 129:
(( 129 – 114 ) / 114 ) * 100 = 13.16% or 13.16% ABOVE the 200-day EMA.
Place the relative strength column first, using those numbers for the primary sort. This will immediately bring components with bullish rotational properties to the top of the list. Add additional columns if desired, with sector coding, 52-week performance and fundamental data that includes revenue and EPS growth rates.
Observations and Strategies
Comparisons between categories uncover rotational strategies not evident from casual observation or review of the headline numbers. Dow risk capital tends to flow between similar components and sub-sectors. For example, Goldman Sachs (GS) and JP Morgan Chase (JPM) show nearly identical accumulation/distribution patterns in the last decade, as a result of financial sector rotational strategies intensified by the 2008 crash and rapid growth of sector ETFs.
Components exiting periods of underperformance can present excellent reward: risk profiles for longer term positions and investments. It’s hard to find these emerging winners with a single data set on a spreadsheet or charting program so consider tracking relative strength trends over time for each component. Graphic displays built from this data can easily uncover hidden gems.
Performance alignment along the capitalization curve points to macro money flow strategies that buy or sell capitalization tiers in reaction to currency and bond movement. This is a result of US Dollar (USD) fluctuations that impact component performance due to multinational exposure that reduces profits when the dollar is rising and increases them when the dollar is falling.
Rotational behavior may also subdivide along bilateral criteria, including cyclical vs. non-cyclical, dividend-paying vs. non-dividend paying, and risk vs. safety. These two-sided strategies often mimic money flows in the broad market, but the Dow always has the power to act independently, regardless of price action or sentiment in the SP-500 and other market barometers.
The Bottom Line
Dow components often trade within a closed system environment, in which capital moves continuously through positions based on technical or macro criteria. Identifying these money flows while in progress supports a variety of profitable trading and investment strategies.
