A 100-Year Old Theory Screams Buy

1 Charles Dow lived more than 100 years ago and wrote about the stock market in ways that still apply today. Dow obviously lived before computers were invented and his ideas are even more amazing when that fact is  considered. He couldn’t easily look at charts to learn from the past because charts were limited and the kind of charts we rely on today didn’t even exist at that time. In this way, Dow was a peer of his contemporary, Albert Einstein, who saw things differently. You may think a comparison between Einstein and Dow is a stretch but both advanced their fields of study in ways that would have been unimaginable a generation earlier. Einstein said “creativity is seeing what others see and thinking what no one else has ever thought.” He dedicated his thinking to physics and changed the world of science. Dow thought about markets and created market indexes, timing strategies and the field of technical analysis. Einstein also said “if you can’t explain simply, you don’t understand it well enough.” Dow defined complex ideas in simple terms. His Dow Theory is an example.

Although Dow wrote about his Theory from 1900 to 1902, the ideas still work and they continue to provide insight into the direction of every major stock market move. The system’s rules are designed for trend following and will always signal a buy weeks after the bottom has been made, while sell signals will come after the ultimate top of the move has been confirmed. Dow was focused on the long term and advised investors to focus on the “middle third” which included the most profitable and least risky portion of the market’s move.

Dow never actually wrote his ideas as a theory. He offered market insights in daily editorials for The Wall Street Journal, a paper he founded. Dow died young and his successors ( A.J. Nelson, William Peter Hamilton and Robert Rhea) at The Wall Street Journal turned his editorials into a complete theory and published the rules in a series of books.

Before founding The Wall Street Journal, Dow had developed the Dow Jones Industrial Average (DJIA) and the Dow Jones Transportation Average (DJTA). He did this in the late 1800’s because he believed the indexes would help understand and anticipate moves of the economy and he found that the tool he designed to forecast the economy would actually help him time the stock market as well.

The theory is based on Dow’s understanding that the economy grows when industrial companies are producing as many goods as possible. As he explained, ““There is a relation between the volume of business and the movement of prices. Great activity means great movements whenever the normal balance between buyers and sellers is violently disturbed.””

In specific terms, he realized economic growth would result in profits for the companies and profits led to rising stock prices. This was tracked with the DJIA. The DJTA reflected the success of the transportation companies (railroads in Dow’s day). Moving goods from factory to market would result in profits for railroads and profit growth should result in rising stock prices.

Dow Theory consists of six principles:

  1. The market has three movements
  1. Market trends have three phases
  1. Markets discount the news
  1. The averages must confirm each other
  1. Trends are confirmed by volume
  1. Trends exist until definitive signals confirm the trend has reversed

The three movements mirrored the movements of the tides in the water. He defined the primary tide as the major long-term trend. A secondary reaction is the intermediate-term corrections that interrupt the primary trend and move in an opposite direction of the primary trend. The minor day-to-day fluctuations in the market were called ripples and Dow said ripples were of no concern to interpreting Dow Theory. The primary trend and secondary reaction can be seen in the chart below. Ripples are ignored in the chart, as Dow suggested.

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There is a logical explanation of why these movements unfold in this pattern. Bull markets, up moves in the primary tide typically unfold in three up moves. The first move, what Dow called accumulation, is the result of smart money accumulating stocks when the economy is bad but expected to improve. Recognition of the improving economy occurs as individual investors buy stocks as economic news and earnings improve during the second phase of the bull market. Speculation occurs when the general public notices that all the financial news is good and begins buying to avoid missing out, driving the third phase.

Downward moving primary tides are bear markets which typically unfold in three down moves. Distribution occurs as smart money sells because they realize high valuations and good economic news can’t continue forever. Fear, the second stage of the bear market, develops as stocks fall and fearful individual investors sell after suffering losses on stocks they bought in the speculation stage. Capitulation, the final stage in the down move, develops when investors are disgusted by the stock market and just sell to get out.

Dow’s third principle is that markets discount the news. Market prices reflect all information that is known about a stock and market prices change in response to news. This principle of Dow Theory is similar to the Efficient Market Hypothesis (EMH) which was developed in the 1960s and demonstrates how far Dow was ahead of his time.

Perhaps the most important principle is that the two averages must confirm each other. To signal a primary tide bear market, both Averages must drop below their respective lows reached in the previous secondary reactions. In other words, both averages must reverse before a new signal is given. A move to a new high or new low by just one Average does not change the direction of the Primary Tide. Under Dow Theory, there is no time limit on confirmation by both Averages although new highs and new lows usually occur within a few weeks of each other.

Dow believed that volume confirmed price trends. Volume indicators may not be as relevant in modern markets since traders can use options, futures and other derivatives to establish positions.

Trends exist until definitive signals confirm the trend has reversed. Only end-of-day, closing prices are considered. Intraday prices are ignored. This ensures that ripples are ignored.

Dow’s theory has been put to the test by professionals for more than a century and by academics. A paper published in 1998 showed that the results of the Theory were “astounding” according to an article in The New York Times.  A portfolio that followed the theory’s signals from 1929 until 1998, buying and selling shares in a hypothetical index fund with no transaction costs, would have outperformed a simple buy-and-hold strategy by about two percentage points a year. The theory-guided portfolio would also have incurred one-third less volatility, or risk, than the market itself. This is impressive because it means Dow Theory provides market-beating results in the long run while reducing risk.

This review of Dow Theory is timely because the averages gave a buy signal in early December when the DJTA set a new all-time high.

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Buy signals have delivered average gains of about 25% and lasted an average of about eighteen months since 1953, an annualized return on investment of about 16% a year. If this is an average bull market, we can expect to be well rewarded for buying stocks over the next year and a half.