So Goes the Nation
Rethinking Dow Theory in a broader supply chain context.
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Tracy and Joe at Bloomberg Odd Lots put out a note yesterday about ProShares’s new Supply Chain Logistics ETF ($SUPL), an exchange-traded fund (ETF) which seeks to capitalize on the financial performance of some of the firms that move goods around the world. Specialized industry ETFs are hardly anything new, but SUPL’s new angle on investing in the supply chain, instead of simply in transportation, gives us a new opportunity to revisit one of modern finance’s foundational theories from a thematic perspective.
Dow Theory…
Shortly after Charles Dow helped create his eponymous Dow Jones Industrial Average in the late 1890s, he published some of his observations on stock market movements in the Wall Street Journal, a publication he co-founded. He died before he had the chance to fully flesh out his ideas, but his successors distilled his writings down to six primary tenets which are known today as the Dow Theory (the “the” is often dropped).
His six tenets form a foundation for technical analysis of financial securities, a sort of self-fulfilling nerd voodoo that relies on behavioral psychology and pretty charts to predict future market movements. Fundamentally speaking, however, Dow’s findings also offer some structure for natural movements in the real economy. One tenet in particular, Indices Must Confirm Each Other, is likely the most popular of the six and what comes to mind when most people think of Dow Theory. Investopedia writes:
Dow used the two indices that he and his partners invented, the Dow Jones Industrial Average (DJIA) and the Dow Jones Transportation Average (DJTA), on the assumption that if business conditions were, in fact, healthy, as a rise in the DJIA might suggest, the railroads would be profiting from moving the freight this business activity required. If asset prices were rising but the railroads were suffering, the trend would likely not be sustainable. The converse also applies: if railroads are profiting but the market is in a downturn, there is no clear trend.
The economy’s health relies on the sale of Things, and Things must be moved from producers to consumers by transporters which are themselves businesses. The success of the movers of the Things is dependent on the success of the makers of the Things. It should stand then, that Dow’s Transportation Average (which persists to this day) only performs sustainably well when his Industrial Average (which needs no introduction) performs similarly, and vice versa: Transports are a leading indicator for the economy as a whole, as proxied by the Industrials. Chuck’s logic, however, makes the most sense in a Thing economy. The subsequent century of economic growth has instead given us a Thought economy.
…And its Decline
Dow’s Industrial-Transportation horse race made a lot of sense at the time—and it still holds water in mainstream finance circles. The reality of the global economy has changed, though. Gone are the days of the Carnegies and Rockefellers, the old-school business tycoons whose billowing smokestacks symbolized America’s industrial might until Dow’s time. The subsequent decades, particularly those leading up to the turn of the millennium, have been characterized by a relative increase in the production of services as opposed to goods.
Nonfarm Payrolls by Industry Sector, 1940 Through Today
As measured by the Federal Reserve’s nonfarm payroll statistics since 1940 (above), the share of people in the U.S. who produce goods, as opposed to services, has decreased from a wartime high of 44.1 percent in February and March 1943 to just 13.8 percent as of today. This is not entirely indicative of a wholesale shift to a Thought economy—goods-producing workers have become decidedly more productive over the years due to advances in technology—but it does illustrate the point that Dow’s Industrials, as approximated by those goods-producing workers above, have seen a marked decrease in share of American (and by extension, global) output to the benefit of the service sector.
Goods, simply put, need to be transported to market. Services, on the other hand, do not need such help. The success of Dow’s Transports and Industrials started to be seen as increasingly divergent.
Transportation and the Supply Chain
It’s all the same, right? Maybe to the uninitiated. Modern supply chain thought, however, is based on a sort of “three-legged stool” model where physical product flows from supplier to consumer along with information and money. This is necessary from a holistic business perspective: physical product can only flow throughout a supply chain with the guidance of information shared among the various parties, and financial resources (i.e., cash) must flow alongside the two to compensate them for their efforts.1
The Three Flows of the Supply Chain
As the three-legged model and empirical day dreaming confirm, the enablers of business in the 21st century are information facilitators and financial transactors as much as they are physical movers of things. A hypothetical trucker, for example, relies on a (likely electronic) load board for direction and his firm might rely on some sort of enterprise resource planning package to integrate that information into its systems and communicate with others. He will likely also rely on financial systems to move the customer’s product: corporate treasury and banking systems. Capital markets, of course, finance the business’s operations and the purchase or lease of the truck itself.
A Truly Representative Supply Chain ETF
ProShares’s Supply Chain Logistics ETF clearly acknowledges this broader thinking of what makes supply chains tick. Its basket of securities reflects a thematic approach to investing, an increasingly popular approach to money management that seeks to follow broader market trends instead of track the performance of specific industries—the success of which themselves are intrinsically intertwined with the success of others. SUPL currently weights the transportation sector as about 92 percent of the supply chain theme, followed by about 5 percent for software and services, and about 3 percent for commercial and professional services (below).2
ProShares Supply Chain Logistics ETF (SUPL) Fund Sector Weightings as of 4/7/22
Amadeus IT Group SA, a Spanish travel technology firm, and Brambles Ltd., an Australian wooden pallet manufacturer, represent about 5 percent and 3 percent of net asset value (NAV), respectively. The remaining components of the fund are mainly transport-related: railroads (Canadian Pacific, Union Pacific, and CSX; all comprising the top three holdings by NAV overall), parcel forwarders (UPS and FedEx, 5 percent and 4 percent, respectively), ocean shippers (e.g, our dear Evergreen), and trucking firms (e.g., Old Dominion Freight Line).
This sector mix is a decent reflection of the three-legged model of global supply chains and the smarty pantses at ProShares clearly took great care to align SUPL with its reference FactSet Supply Chain Logistics Index (an index which admittedly appears to exist for this purpose alone). Index adherence aside, a 92 percent weighting towards transporters alone is probably not indicative of which sectors truly drive today’s supply chains.
A true allocation of all parties to the global supply chain is ever-changing and outside the scope of a small-time Substack post. It would stand to reason, though, that in addition to the railroads, ocean shippers, and truckers that comprise most of SUPL, a truly reflective supply chain ETF might be weighted more towards supply chain technology firms, warehouse-focused real estate investment trusts, or third-party logistics providers (which SUPL holds but not substantially). Even staffing firms and publicly traded supply chain consulting firms may perform in meaningful correlation to the ebbs and flows of global supply chains.
Broadening the scope of SUPL with this expanded definition of “supply chain” in mind should be done carefully. Like the real-life nature of supply chains themselves, the scope of a wider index may quickly grow to a point where the chain includes the very firms that it serves—a full circle which would generate so much “feedback” that it defeats the purpose of building a specialized ETF in the first place or using Dow’s theory as a predictor. Rethinking what goes in to delivering the products that define he world around us, however, might be a meaningful pursuit for investors and consumers alike.
Recent management thinking has included a fourth “return” function to handle returns and end-of-product life recycling.
SUPL’s 0.45 percent allocation to healthcare equipment and services is probably a statistical remnant of how ProShares internally calculates sector weightings.