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Improving the Dow Theory

Written By Briton Ryle

Posted February 4, 2015

I love stock market patterns. They can prove very useful by giving you a heads up when a stock or sector or the broader market as a whole is oversold and should be bought, or overbought and should be sold.

One of the best known and oft used patterns, the Dow Theory – which dates back more than a hundred years to a series of 255 editorials written by Charles Dow, the founder and first editor of the Wall Street Journal, and the creator of the Dow Jones Industrial Average index – is currently giving us a signal: Sell, Sell, Sell!

“The U.S. stock market’s major trend now is down, so act accordingly. That’s what the Dow Theory, the oldest stock market timing system that remains in widespread use today, is saying,” reports MarketWatch, which is owned by Dow Jones and Company, which also owns the Wall Street Journal.

Yet as with most theories based on market patterns, many of the conditions required to trigger a “buy” or “sell” signal are rather vague and unquantifiable, and are very much open to interpretation. As MarketWatch cautions, “Not all adherents of the Dow Theory see eye to eye.”

Many patterns prove themselves to be rather useless for the simple reason that they are backward-looking, not forward-looking, often relying on weeks’ worth of data that – by the time you act on them – can be near the end of their run already. Even worse, these can be outright counterproductive by giving you the wrong signal at the wrong time, causing you to sell yourself out of a rising market.

Is the Dow Theory giving us the wrong signal now? Let’s take a closer look.

The Dow Theory

Interestingly, Dow himself never presented the Dow Theory as a trading system to be used in stock trading and investing. Rather, one of his successors, William Peter Hamilton, who was the fourth editor of the Wall Street Journal, along with two other colleagues compiled Dow’s 255 editorials to produce the Dow Theory, presenting it as a means of helping traders and investors identify bull and bear markets.

Though the theory’s six major tenets can be rather complicated, they can be boiled down into three main concepts, as MarketWatch describes:

• “Both the Dow Jones Industrial Average and the Dow Jones Transportation Average must undergo a ‘significant’ correction from new highs.”

• “In their subsequent ‘significant’ rally attempt following that correction, either one or both must fail to rise above their pre-correction highs.”

• “Both averages must then drop below their respective correction lows.”

In a nutshell, then, the Dow Theory issues a sell signal when both the DJIA and the DJT correct significantly, fail to rise above their pre-correction highs, and then fall below their corrective lows.

You know what? According to that description, that’s precisely where the markets are today. As graphed below, both the DJIA (beige) and DJT (black) suffered significant corrections in the first half of January (red) – condition one met. Both have failed to overtake their pre-correction highs (brown dot) – condition two met. And then both dropped below their corrective lows (pink) – condition three met.

According to this, the market is about to plunge. A look at how past examples played out could give us cause for concern.

how to improve dow theory 1


It Works, But Not That Well

There are plenty of examples from the past when the Dow Theory has worked remarkably well in identifying hefty corrections, one great example being the correction of 2010.

As graphed below, both the DJIA and the DJT suffered significant corrections of some 8% to 9% (red) – condition one met. They then rallied, but failed to overtake their pre-correction highs (brown dots) – condition two met. They then fell back down below their corrective lows (pink) – condition three met. The Dow Theory issued a sell signal at this point.

If you had sold below the red lines, you would have saved yourself the subsequent drop of 10% on the DJT and 7% on the DJIA (from top of pink to bottom of purple). That really is a fine savings.

But when would you have bought back in? During the months of May and June, the market kept failing to overtake the pre-correction high, and kept falling to new lows after each failed attempt. It wasn’t until November when the two indices finally overtook their pre-correction highs (end of blue and yellow lines).

Yet if you had bought your shares back at that time, you would have ended up selling the Dow in the pink lines (at -8% below its recent peak) and buying at the end of the yellow line (at 0% flush with the peak). The net result? You would have sold low and bought back high for a loss of 8%.

The market continued to rise, and you would have continued to enjoy gains. But your gains would trail the DJIA by 8% all the way up because of the trade you placed based on the Dow Theory.

how to improve dow theory 2


Let’s look at a couple more examples from 2011 and 2012. Both the DJIA and DJT experienced corrections in May of 2011 and March of 2012 (red drawn for DJIA only for less clutter). They then both rallied, but failed to overtake their pre-correction highs (brown dot). They next fell below their corrective lows (pink). The Dow Theory here issued sell signals in both cases.

Had you sold at those times you would have spared yourself the losses that followed (purple), which measured some 11% and 5% respectively. Those are pretty nice savings.

However, you would not have bought back again until “both” indices overtook their pre-correction highs (ends of the blue and yellow lines). The net result would have been a loss of 7% from the 2011 sale, and a loss of 5% from the 2012 sale. Again, selling at the pink level results in a “temporary” savings during the rest of the correction, but in a “permanent” loss by the time you buy back again above the pre-correction high.

how to improve dow theory 3


There are numerous smaller cases when the Dow Theory issued sell signals (green circle above) scattered all throughout time. But for such small pullbacks, the risk of being caught in cash when the market resumes its rise is greater than the risk of being caught in stocks during these small pullbacks.

While the Dow Theory does help to identify prolonged corrections, it does not catch them in time to be very useful. Most of the time it will spare you only the bottom third or bottom half of the correction, which might amount to 5% or so.

In the case of the great 50% correction of 2008, it would have saved you as much as 25%. Yet on the way up, it would have cost you more in missed upside potential while you waited for that entry point at higher levels. After the 2008 correction, it took the market until early 2012 before reaching its pre-crash highs, netting you a loss of 25% instead of a savings of 25%. Actually the loss would have been even more considering the loss of over three years’ worth of dividends.

How to Improve on the Dow Theory

Instead of selling positions on mass when the Dow Theory issues a sell signal (at the pink lines), traders would be better off simply taking advantage of these dips and buying a few more shares every 2 or 3 percentage points down.

In fact, combining the Dow Theory with this “scaled-down buying program” would increase your purchases on the way down after the Dow Theory issues a sell signal. That is, after the market dips below its corrective low (pink lines) you would start aggressively buying. In this way, you would be buying during the bottom third or bottom half of the correction. Then, during the recovery that follows, the extra shares you purchased in the bottom portion of the correction would pay you a substantial bonus.

Other Indicators From Which to Take Cues

Yet there are other indicators traders can use to squeeze a little advantage out of the movement of the markets which are not nearly as complicated as the Dow Theory.

For instance, there is the Slow Stochastic indicator measured on a scale of 0 to 100, where a reading below 30 shows a market or stock to be oversold and signals a buy, while a reading over 70 shows overbought and signals a sell. Though here, too, the stock could continue to become even more oversold or even more overbought, and rarely gives a concrete entry or exit timing.

There is also the Moving Average Convergence Divergence (MACD) which is measured on a scale of -100 to +100, or sometimes -30 to +30, or other span. In this case, a reading below zero indicates oversold and should be bought, while a reading above zero indicates overbought and should be sold. But here as well, the market could continue moving in that direction, leaving you with a losing short position in a rising market or a losing long position in a falling market.

With all of these indicators – the Stochastic, the MACD and the Dow Theory – at best they will do for you is issue a sell signal about halfway through a correction. That, however, is the time to be buying, not selling. Combining the Dow Theory, MACD, Slow Stochastic or almost any other market indicator would work best in conjunction with a scaled program of buying one the way down and taking profit on the way up.

Just don’t overdo it. Never buy more than you can afford, and never sell too much on the way up. The market has an upside bias, after all, and tends to rise over time. For this reason, using the Dow Theory to sell in the middle of a correction is really a mistake. What most people call a Dow Theory sell signal is better interpreted as a scaled-down buy signal instead.

Joseph Cafariello