The Evolution of the Dow Theory of the 21st Century

THE EVOLUTION OF THE DOW THEORY OF THE 21ST CENTURY
Presentation at the 160th Birthday Celebration of Charles Dow at the Museum of American Finance in New York City sponsored by the Market Technicians Association, Dow Jones Indexes, and the MTA Educational Foundation on November 3rd, 2011
by Jack Schannep
Editor,  Schannep Timing Indicator & TheDowTheory.com
Author, Dow Theory for the 21st Century

     Thank you Phil Roth for that nice introduction, and especially for inviting me to be a part of today’s program; it is a real honor to be able to participate in this celebration of Charles Dow’s 160th birthday.  My daughter asked me why I had been invited and I told her ‘because Charles couldn’t make it’, but we’ll hear from him shortly.  I started my book with this classic quote from Charles Dow and think it should be recited again as it is the very essence of Dow’s Theory: “A person watching the tide coming in and who wishes to know the exact spot which marks the high tide, sets a stick in the sand at the points reached by the incoming waves until the stick reaches a position where the waves do not come up to it, and finally recede enough to show that the tide has turned. This method holds good in watching and determining the flood tide of the stock market”.  As you know from Robert Colby’s previous presentation, the record of the traditional Dow Theory has been very impressive. It has become the benchmark against which all other market timing has had to compete.  Many have tried to improve on the Dow Theory’s results, and I am but one of the latest, and today I’ll briefly describe my efforts to add value to the original Dow Theory for the 21st Century.  Robert Rhea in his The Dow Theory wrote in 1932 the “the usefulness of the Dow Theory improves with age.  Certainly a more comprehensive study of the subject is possible with a 35-year record before us than when Dow worked with the figures of only a few years, while those who use it 20 years from now will have a greater advantage than we now enjoy.”  And now we’re 80 years later, so we have an even greater advantage.

     In my book Dow Theory for the 21st Century, Technical Indicators for Improving Your Investment Results, I illustrate several improvements within the framework of Charles Dow’s original thoughts and premises that would have increased the performance of the traditional “Dow’s Theory” over the last 50+ years. The first improvement I added was to begin buying during “capitulation”, a word Charles Dow never uttered but he clearly alluded to with his discussion of the final phase of bear markets when he described “distress selling of sound securities, regardless of their value…..”  Our previous speaker, Robert Colby has described it as the “Disgust” phase.  Robert Rhea in his 1932 classic book, The Dow Theory,described it as “a semi-panic collapse (and) it is wise to cover short position and even perhaps make commitments for long account”. There have only been 15 occasions over the past 50+ years when Capitulation, as we measure and identify it, has occurred and each time a Dow Theory Buy signal has followed, about 4 months later, on average. One half of those 15 times occurred within a day or two of the Bear market lows – four were on THE day of the lows.  The average was 14 days and 4.6% above the lows; the median was within 3 days and 2% of the lows.

     As market technicians I suspect you’ll be interested in the details and origin of my Capitulation Indicator. When I was a young broker at Dean Witter in the 1960’s they formed a department called COMPARE (COMPuter Assistance to Research).  One of the calculations they made back then, and which I have kept up to date since that department went kaput years ago, has to do with a short-term oscillator which measures the percent of divergence between the three major stock market indices (DJIA, S&P500, and the NYSE Composite), and their time-weighted moving averages.  When all three indices are simultaneously in double digits below those respective moving averages, we have Capitulation.  Those 15 dates, market levels, and the subsequent returns over various timeframes are shown below.   You’ll see that the end of the last 8 bear markets were signaled, and 3 of the 7 before that.  Some bear markets end, however, with a whimper, hence no Capitulation indication.

The Schannep Capitulation Indicator

Data from 31 December 1953 forward (available in real-time since 1969)

*Trading days away and percentage down to S&P and/or DJIA Bear market lows
**Closed out due to Bear market definition (-16% on DJIA & S&P) being met during the period shown
***Not closed out at definition due to simultaneous new capitulation offset
****To-date

     I examined other possible capitulation indicators: the Equity-only Put/Call Ratio, Net Cash Into/Out of Equity Funds, New 52 Week Lows as a Percentage of Issues Traded, the VIX Volatility Index, Lowry’s “90%” Indicator, the Arms Index, and the 200-Day Moving Average.  All of this was included in a paper I submitted in the M.T.A.’s 2005 Charles H. Dow Award competition entitled: “Capitulation – The Ultimate Bear Market Low Indicator” but unfortunately, no award was made that year or the next.  If you’re interested, the paper is printed in it’s entirety in my book and in the Subscriber’s area of our website at www.thedowtheory.com. Don’t forget THE, otherwise you’ll get a friendly competitor’s website. If you don’t have access to either the website or my book – if you’ll give me your card or e-mail me at Editor@thedowtheory.com I’ll get a copy to you.

     The second enhancement was also an original Charles Dow idea: that a secondary reaction lasts “from ten days to sixty days” (Wall Street Journal, January 4th, 1902) rather than the widely accepted “from three weeks to as many months”. Things DO happen faster in the 21st century. This was the thesis of Alvin Toffler’s Future Shock, as well as a premise in my more recent book.  By using Capitulation as the time to start buying and shortening the timeframe for the steps of the Dow Theory to occur, the result is a signal within a month and a half average of Capitulation, and at a 5% better/lower average entry level than the traditional Dow Theory.

     Another advancement was not available in Charles Dow’s day; that is adding the broader Standard & Poors 500 Index, in addition to Dow’s own Industrial Average and the Railroad/ Transportation Average.  The definition of bull and bear markets is also involved: Charles Dow only had 5 years to work with his 2 indices and concluded that a bull market, or bear market was “the great move covered from four to six years”.  He actually thought that a complete market cycle would last 10 years, with 5 years in a bull market and 5 years in a bear market.  We’ve had 110 more years of historic data than Dow had and now know that Bull markets have averaged less than three years, and Bear markets less than a year and a half.  Dow’s expectation was fulfilled, however, 100 years after his death when the 2002-07 bull market lasted exactly 5 years to the day.  My own definition is, indeed, specific: A minimum +19% advance, or a minimum 16% decline, on both the Dow Jones Industrials and the S&P500.  These percentages are reciprocal numbers of each other, unlike the often used plus or minus 20%.  When Bull markets meet the +19% threshold they then go on some 93% of the time to at least a +29% gain.  When Bear markets drop 16% they then go on some 81% of the time to at least a -24% decline.  It should be remembered that Dow’s Theory was a barometer to predict the future course of business activity.   A recession follows my definition of a -16% decline some 73% of the time. Using the standard -20% figure missed three recessions that the -16% definition captured.  I use the attainment of my definition of bear market as a “stop-loss” point for completing a Sell signal, or the definition of bull market as a “stop-buy” in the case of a Buy signal, when such signals had not already been completed by our interpretation of the Dow Theory for the 21st Century.

The ‘rules’ for signals as described in my book, and on our website can be abbreviated as follows:

The primary trend is interrupted by a secondary reaction lasting a minimum of 10 calendar days. The timeframe for a Buy signal is shortened to half that when it follows capitulation.

1)    In an up market, that secondary reaction will be a pullback, after which a bounce must rise at least 3% on one or more of the three indices and take at least 2

days (this eliminates ‘one-day wonders’).

2)    In a down market, the secondary reaction will be a bounce, after which a pullback must drop the same 3% over least 2 days (eliminates ‘flash crashes’/etc).

3)    THEN, in a formerly UP market, once either the Industrials or Transports confirm the S&P500 in falling below the previous pullback lows that qualifies as a

Sell,….or in a formerly DOWN market a rise above the previous bounce highs qualifies as a Buy.

4)    Of course, as was Charles Dow’s practice, we use actual closing prices. There are some lesser details and nuances that time doesn’t permit our getting into.

The specific “rules” for signals can be found in the Special Report “The Dow Theory for the 21st Century Complete Record” in the Subscriber’s Area.

The calculations from 12/31/1953 to 12/31/2010 with dividends on the Dow Jones Industrials included during invested periods, and interest from 3-month Treasury notes included when not invested, show what would have resulted in the following comparison:

Buy and Hold:                                                10.44% average annual increase.
Dow’s Theory:                                                11.89%
Dow Theory for the 21st Century:   14.07%

$1,000.00 invested in each would have grown to:

Buy and Hold:                                     $   286,561
Dow’s Theory:                                     $  605,631
Dow Theory for the 21st Century:   $1,819,102

Finally, you may be interested in the current status of our interpretation of Dow’s Theory.  We had the same sell on August 2nd that Robert Colby and most other traditional Dow Theorist’s had at the 11,886 level on the DJIA.  Then on August 8th, just six days later and over 1,000 points lower, we entered into Capitulation at the 10,809 level whereupon our ‘rules of engagement’ dictated buying a 25% position.  We completed the Buy-in process in August and I wish I could tell you we were 100% invested during the October run-up BUT instead we were scaled back by the October 3rd false breakdown, leaving us just 25% invested during the amazing 15-16% run-up in October.  And that reminds me of one of Charles Dow’s hypothesis: “The theory is not infallible. The wish must never be allowed to father the thought”.   I believe we are in the same boat again with the traditional Dow Theory currently in the 3%+ setback waiting for the Buy signal to be completed by a run up to newer highs. The difference is we are 25% invested from the Capitulation and another 25% in this setback, so are now 50% invested, waiting for whatever will come next.

     My thanks to Charles Dow for his Theory and guidance which has produced so many years of profitable signals, and I wish the same for you and thank you ladies and gentlemen for your kind attention.

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