The Dow Theory

As I sit getting ready for my exam, one of the areas I will be tested on is the Dow Theory, one of the cornerstones of technical analysis.  It is one of the oldest and best known methods used to determine the major trend of stock prices derived from the early 1900 writings of Charles H. Dow.  If the name doesn’t ring a bell, Mr. Dow is the founder of The Wall Street Journal and who created the first index/averages such as the Dow Jones Industrials, Transportation and Utilities. 

Even in today’s volatile and technology-driven markets, the basic components of Dow Theory still remain valid more than a century later. Developed by Charles Dow, refined by William Hamilton and articulated by Robert Rhea, the Dow Theory addresses not only technical analysis and price action, but also market psychology. While there are those who may think that it is different this time, a read through The Dow Theory will attest that the stock market behaves the same today as it did a 100 years ago.  It’s not about the market it’s about the people who make up the market.  The market may change but the people don’t.

Without going into the depths of the Theory as it would require an entire book to cover, one of the major values it provides is market buy and sell signals. While I am no Dow Theory expert, my interpretation is that a sell signal triggered last Monday.    

While there is no foolproof and perfect indicator, the Dow Theory included, it does have a very good long term track record.  The website compiled some excellent data regarding the success/failure of the Dow Theory past market signals and I would highly recommend those who would like more detail to check it out as I believe it is the premier source.

Market results after “SELL” signals were as follows:

Original (Traditional) Dow Theory SELL Signals and the further S&P500 Loss to the final Bear Market Lows*:

What their data shows is since 1953 the Dow Theory provided 25 Sell signals and 24 were followed by market declines, the average loss being 14.3%. The one signal that did not decline, that being in 2012, ended exactly where it started.

In today's uniquely managed markets, Dow Theory signals may be of little or no worth, but considering its past performance (yes, yes I know past performance is not indicative of future results) investors should heed at their own risk. As a minimum it should be used in conjunction with other analysis to determine a course of action based upon the weight of all the evidence. Right now the evidence is piling up for the bear camp.