Well it occurred to me that it has been awhile since I’ve (proudly) played the role of “systems geek." So this seems like a good week to break that streak. I will refer to the system detailed in this article as the ITU System, or ITU for short. The ITU System is always in the market in some form, either:

a) Long the Dow Jones Industrials Average
b) Long the Dow Jones Transportation Average
c) Short the Dow Jones Transportation Average

ITU looks at the relative performance of the Dow Transports versus the Dow Utilities to determine when to switch from one index to another. In a nutshell, it buys the Transports when they have sharply underperformed the Utilities (and holds them until they are back to a more normal relative level). Likewise it sells short the Transports when the Transports have sharply outperformed the Utilities (and holds that short position until the Transport/Utility relationship is back to a more normal level). Lastly, if neither of these situations is presently in force, the system simply buys and holds the Dow Industrials.

At this point, the systems types (you know who you are) are tingling with anticipation while all the rest are saying, “huh?”  So let’s spell out the calculations and rules.

Indicators:
A = Dow Jones Industrials Average (DJIA)
B = Dow Jones Transportation Average (DJTA)
C = Dow Jones Utility Average (DJUA)
D = B / C (Transport/Utility Ratio)
E = 250-day moving average of D
F = D / E (todays Transport/Utility Ratio divided by 250-day moving average)

In a nutshell, we will compare the ratio between the Transports and the Utilities and then compare the latest reading of that ratio to the 250-day average of such readings. When the Transports are vastly underperforming the Utilities this ratio will drop below 1.00 and vice versa. If this ratio reaches an extreme level as discussed below, then a trade in the Transports – either long or short – is entered. In the meantime a position is held in the Dow Industrials.

Rules:

• If F <= 0.90 then Buy DJTA; sell when F >= 1.10, and move back into Industrials.
• If F >= 1.23 then Sell short DJTA, cover short position when F < 0.98 and move back into Industrials.
• If no position in DJTA is presently held, then hold Dow Jones Industrial Average.

Okay, that ought to just about clear it up – except of course for those who don’t understand hieroglyphics. So let’s take a slightly closer look at how this works.

Note that the indicator value F is simply today’s Transport/Utility ratio divided by the 250-day moving average such daily readings. Chart 1 displays the daily ratio of the Transports divided by the Utilities with the 250-day moving average overlaid. When the lines are rising it means that the Transports are performing relatively better than the Utilities, and vice versa.

Chart 1 – Daily Transport/Utility Ratio and 250-day moving average since 6/16/1987

In Chart 2 we divide the blue line from Chart 1 (the daily Transport/Utility ratio) by the purple line in Chart 2 (the 250-day moving average of Transport/Utility ratios) to get a value that fluctuates about the neutral 1.00 level.

Chart 2 – Daily Transport/Utility Ratio divided by 250-day moving average since 6/16/1987

Chart 3 displays the growth of $1,000 invested using the system versus $1,000 invested in the Dow Industrials on a buy-and-hold basis since June 1987. First the good news: While $1,000 invested in the Dow has grown to $4,715, that same $1,000 invested using this system has grown to $70,629 during the same time. This works out to about a 23.3% annual return for the system versus 8.4% for the buy-and-hold approach.

Of course, like any mechanical system, this one is not without it faults. There have been several drawdowns in excess of –30%. So this is by no means an “all weather” method and is clearly not for the faint of heart. Nevertheless, looking at annual results, the system outperformed a buy-and-hold approach 15 times, underperformed 4 times and equaled the buy-and-hold return 3 times. So far this year, the system is up over +8% versus a decline of 14% for the Dow Industrials.

Chart 3 – Growth of $1,000 invested using system since 6/16/1987 (purple line) versus buy and hold using Dow Industrials (blue line)

Summary

So is this the next great sure fire, you can’t lose approach to trading?  Hardly. Putting an interesting idea such as this into action requires a bit of reflection before diving in. As I mentioned earlier, this system is not without some serious equity fluctuations. The ability to trade through such declines is not something to be taken lightly. Likewise, at the moment I am not aware of any “inverse” mutual funds or exchange traded funds. So at the moment, the only way to “short the transports” is to sell short shares of iShares Dow Transports (IYT). Not everyone’s cup of tea.

Still, the real purpose here is not to prompt you to rush out and start using this or some other similar system. The real purpose is simply to illustrate the potential usefulness of looking at the markets in unique ways and attempting to spot opportunities beyond buying and holding (hoping?) for the long run.  

To search for previous articles written by Jay Kaeppel, please click here.


Jay Kaeppel
Staff Writer and Trading Strategist
Optionetics.com ~ Your Options Education Site