This article was originally published on Marketwatch on October 7, 2015
One of the few hypotheses of Charles Dow’s Original Theory is that “the theory is not infallible.”
Despite that disclaimer, the record over the 100-plus years of its existence is really quite exceptional. In my book “Dow Theory for the 21st Century, Technical Indicators for Improving Your Investment Results,” I calculated that the record of buying and selling whenever the theory produced “an indication of change,” better known as a buy or sell signal, outperformed a buy-and-hold approach by 1 to 2 percentage points a year. Not impressive, you say? With compounding over the years, the difference is huge.
On Aug. 20, the Original Dow Theory reversed its January 2013 buy signal at 13,649 on the Dow Industrials, and gave a sell signal at 16,990 that was recognized by most people with an understanding of the theory. Some saw the signal and chose not to follow it for various reasons. (One of the hardest things for most investors to do is to “pull the trigger,” particularly to sell.) It happens that the Transportation Index had been declining since the end of 2014, and that divergence had been a warning sign of possible danger ahead. In our market newsletter, TheDowTheory.com, we turned on the cautionary “yellow” light in March, and changed to a decisive sell, or “red,” as the broader market fell toward capitulation in August.
Counterpoint: The Dow Theory suggests stocks are about to tank, but it’s wrong
So where do we stand now? Thus far, the correction lows on Aug. 25 were some 12% to 13% below all-time highs, from which there was a three-week bounce into September. That being a qualifying secondary reaction, it set up the possibility of a reversal to a Dow Theory buy signal. Later in September was a setback, which successfully tested and held above the August lows, which is encouraging, and now what is needed is for the Transports to join the Industrials in surpassing their bounce high of 8,215.44. For the Original Dow Theory, the interpretation to get a buy signal is really just that simple. The odds of the sell signal being profitable are quite favorable. There have been only seven of 24 such signals since 1953 that did not go into a bear market that year, making it hard to ignore any Original Dow Theory signal.
‘The usefulness of the Dow Theory improves with age … those who use it 20 years from now will have a greater advantage than we now enjoy.’
For those who wonder if it might be possible to improve on the centuries-old Dow Theory, we invite you to review the free section of our website, TheDowTheory.com, to see how we have updated and improved the results in the 21st century. There are four such improvements to the Original Dow Theory comprising our interpretation, making it the “Dow Theory for the 21st century.”
The first was the addition of “capitulation,” which we have specifically identified on several previous occasions as the time to start buying.
The second enhancement was to shorten the time frame of a secondary reaction “from 10 days to 60 days,” rather than the widely accepted “from three weeks to as many months.” We believe that things happen faster in the 21st century than in Charles Dow’s time.
The third improvement was to add the broader S&P 500 Index, which was not available to Charles Dow.
Finally, the fourth update was the addition of our definition as a bear market being a 16% decline, not the widely accepted 20%. Historically, when the market drops 16% on both the Dow Industrials and the S&P 500, it then tends to fall 24% about 69% of the time, with a recession following 67% of the time.
We have found that these changes add an additional 1 to 2 percentage points a year to the results.
Robert Rhea, in his classic 1932 book “The Dow Theory,” wrote that “the usefulness of the Dow Theory improves with age … those who use it 20 years from now will have a greater advantage than we now enjoy.”
And certainly over 80 years later, we have an even greater advantage. Overlook the Dow Theory for the 21st century at your portfolio’s peril.
