Charles Dow's Original Editorials and Their Relevance Today

A Buy and Hold Strategy Worth Considering

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By Paul Shread

A money manager I know recently gave me a copy of Nick Murray’s “Behavioral Investment Counseling.” The book is aimed at financial planners, but almost anyone who invests in stocks could benefit from reading it. It’s surprisingly well written for a financial book, and it also makes an unusually persuasive case for buy-and-hold: That most investors chase performance, buy high and sell low, and in the process lag the performance of the average mutual fund or stock index by more than half.

It got me thinking: What would I feel comfortable buying and holding? Here’s my answer. First, I’m a fan of Dow stocks. In the small 30-stock universe of the DJIA lies enough diversity to fuel any portfolio. The index tends to have higher-quality stocks that won’t set the world on fire, but likely won’t go out of business on you either, although the financial crisis of 2008 marred the index’s long history of relatively safe component companies.

Second, I’ve never been a fan of the Dow’s price-weighted approach, where a $200 stock wields outsized influence, or the S&P’s cap-weighted approach. Studies have shown that equal weighting – buying stocks in the index in equal amounts – tends to modestly outperform the indexes, perhaps for the simple reason that it lessens the influence of stocks that have already had quite a run.

Third and last, I wasn’t a fan of financial stocks even before the 2008 crisis – I was short New Century Financial years before it became the first victim of the subprime mortgage crisis in 2007 – so let’s toss JP Morgan and Goldman Sachs while we’re at it, which has the added benefit of reducing the beta of our portfolio by getting rid of the two highest-beta stocks.

So there you have it, 28 Dow stocks bought in equal measure. It might even work well as a buy-and-hold strategy for when the stock market is on a Dow Theory buy signal, as has been the case since 2009.

I started tracking this portfolio strategy today, in part because I expect a correction between now and October and I want to see how this approach performs in down markets, which, after all, is where buy and hold investors face their greatest test. Theoretically, this strategy should have lower volatility than the Dow while offering similar performance, but only time will tell. I’ll post periodic updates in this space on the performance of this strategy and will rebalance the portfolio on the first trading day of each new year. If a stock is dropped from the Dow, I’ll drop it and add whatever replaces it.

Happy investing.

Paul Shread is a Chartered Market Technician and member of the Market Technicians Association. He is a co-author of “Dow Theory Unplugged” and has been testing stock market trading and investing strategies for twenty years.

The Dow Holds Up, But Expect a Correction This Year

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The stock market has been wobbly since last May, but it continues to hold up. My barometer – the NYSE advance-decline line (NYAD) – lagged from May until it broke out late last year, and it is leading the recovery this month. So while the long negative divergence last year was a warning sign, the new highs in the NYAD since then suggest that any decline may be limited, at least until the NYAD peaks before the rest of the market.

But as mid-term election years tend to produce important stock market lows (think 2002, 1998, 1990, 1982, 1974 and so on), and sentiment indicators like Investors Intelligence are showing a general lack of bearishness, I’d be quite surprised if the stock market escapes this year without a significant sell-off, perhaps even a mild bear market.

Dow Theory and breadth remain positive, however, so the warning signs do not appear dire for now. That doesn’t rule out even a 25% bear market, as happened in 1946 and 1976 without an NYAD divergence, but 80 years of stock market history suggest that worse than that is unlikely without deterioration in the NYAD first.

Paul Shread is a Chartered Market Technician (CMT) and co-author of “Dow Theory Unplugged: Charles Dow’s Original Editorials and Their Relevance Today.”

Dow Theory Turns Positive

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I warned back in May that the shaky stock market and Dow Theory sell signal might not lead to a big decline because the NYSE advance-decline line wasn’t signaling broad market weakness before the Dow topped out.

As I’ve noted before, market tops that haven’t been preceded by erosion in the A-D line have led to a few declines in the range of 20%, most recently in 2011, but to get a major bear market of 25% or more, historically that’s required some erosion of internals before the market peaked. We didn’t get that before the market peaked in March 2012, and with new highs for the year in the Dow and Transports since then, it’s time to declare Dow Theory on the side of the bulls again.

For the record, the Dow Theory sell signal occurred at 12,442 on May 17, and I’ll call the buy signal at 13,350, when the Transports broke out of a six-month range two weeks ago.

Because Dow Theory buy and sell signals take a long time to form, it’s best to look for signs of broad market erosion before putting too much credence in a Dow Theory sell signal. In 2011, for example, the banking sector had been weak for months before the market top and subsequent 19% decline; we saw no such warning signs this time around.

There are no guarantees as to where the market goes from here or how far it goes, but it’s past time to abandon a Dow bear signal that never stood much of a chance.

Paul Shread is a Chartered Market Technician (CMT) and co-author of “Dow Theory Unplugged: Charles Dow’s Original Editorials and Their Relevance Today.”

Another Dow Theory Sell Signal

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The Dow Industrials and Transports recently suffered a couple of significant breakdowns, creating a sell signal under Dow Theory. The Dow broke down out of a two-month trading range, while the Transports broke down out of a three-month range, both satisfying my requirement for a significant pattern of a month or more.

While any Dow Theory signal should be respected, we would note that this one once again came without a negative divergence in the NYSE advance-decline line, as the broad list did not begin to decline before the major indexes. So while the market may indeed go lower, historically a sell signal accompanied by broad market strength hasn’t gone very far. There have been a few 20-25% declines under such circumstances, including last summer’s 19% decline, but we’re unlikely to see a major bear market as long as there is enough liquidity to support the broader market.

As Dow Theory signals take a while to form, it’s possible the next buy signal could come at a higher price, as happened last year when Dow Theory issued a sell signal at around 11,900 in August and a buy signal some 400 points higher a few months later.

Past performance is no guarantee of future results, of course, and any Dow signal should be respected. This may still be a good time to lighten up on high-beta, economically-sensitive stocks, for example.

Paul Shread is a Chartered Market Technician (CMT) and co-author of “Dow Theory Unplugged: Charles Dow’s Original Editorials and Their Relevance Today.”

Dow Theory Flashes a Buy Signal

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Last week, the Dow Jones Industrial and Transportation averages closed above their October highs, issuing a buy signal under Dow Theory and negating the sell signal from early August.

The buy signal looks pretty solid, meeting my ideal conditions – a rally in both indexes of at least 18 trading days from trough to peak, a decline of the same duration from peak to trough, followed by new highs in both the Dow and Transports.

The buy signal also comes some 400 points above the August sell signal. That the August sell signal proved to be a relatively weak one should come as no surprise to students of market breadth, as the lack of deterioration in the NYSE advance-decline line suggested that there might be enough liquidity to limit the bear market’s damage.

Dow Theory offers no prediction on how long or far any rally will carry from here; the date of the next sell signal will tell us that. But for now, conditions appear favorable for stocks.

There is one negative to note here, however; that same advance-decline line that earlier suggested strength is now lagging the market, still below its November highs. Traders will want to see that negative divergence wiped out soon with a new high in the A-D line.

Paul Shread is a Chartered Market Technician (CMT) and co-author of the book “Dow Theory Unplugged: Charles Dow’s Original Editorials and Their Relevance Today” from W&A Publishing.

The Dow, Transports Break Out

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The Industrials and Transports broke out of a two-month trading range on Friday, so the market has something positive to build on here. That said, we’d note a couple of reasons for caution.

First, the indexes broke down out of these ranges two weeks ago and immediately reversed, so be on guard for a similar reversal. And second, a “line” isn’t necessarily the strongest of Dow Theory patterns; to quote Robert Rhea, a breakout of a “line” indicates “a change of the general market direction of at least secondary, and occasionally even of primary, character.” In other words, it’s not viewed as strong a buy signal as persistent new trends in the indexes.

So what to look for: A good Dow Theory buy signal will be followed by at worst a modest pullback, so a sharp drop back into the trading range would be a negative sign for the market. To the upside, the Dow Theory sell signal area of 11,865 will be the first test.

Paul Shread is a Chartered Market Technician (CMT) and co-author of the book “Dow Theory Unplugged: Charles Dow’s Original Editorials and Their Relevance Today” from W&A Publishing.

Dow Theory Tries to Turn Bullish

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There’s a lot going on here in the stock market, as both Dow Theory and the stock market in general are flirting with some critical levels, both to the upside and the downside.

To start with, both the Dow and Transports (see charts below) are stuck in two-month trading ranges, what Dow Theorists might call a “line,” although these trading ranges are wider than the traditional definition of 5%. The indexes broke down out of those trading ranges last week – then closed back inside them the next day. While the action is at least somewhat positive – and we’ll get back to this subject in a moment – Dow Theory now views the market as bearish until the indexes close above the top of the trading range, which would be the August closing highs of 11,613 on the Dow and 4684 on the Transports.

We’ll cite Robert Rhea’s great book The Dow Theory, the first to clearly spell out the rules of Dow Theory.

In the chapter on lines, Rhea quotes William Peter Hamilton, Charles Dow’s successor at the Wall Street Journal, that once a line is broken to the downside, “it would be necessary for the last high point to be reached again before we could assume anything like a bullish indication in the average.”

So Dow Theory is pretty clear here – the market can’t be considered bullish again until the Dow and Transports close back above their August highs, unless they form bullish patterns at lower prices.

And now onto the recent low in the Dow, which is interesting for another reason. First, some background based on my own personal research. Everyone knows that the best gains for the stock market tend to follow the low point of the midterm congressional election year (think 1990, 1994, 1998, 2002 and so on), but what most traders don’t know is the importance of that midterm year low itself. From the formation of the Federal Reserve in 1913 until today, every midterm year low has supported the market for at least the next three or four years – with the only exceptions of 1930 and 2006. Both of those lows broke prematurely – the 1930 low lasted just four months, while the 2006 low of 10,667 was broken in September 2008, the day before Lehman Brothers imploded. Thus what is common between the two breakdowns is that they ushered in the two worst systemic crises of the last century, a point underscored by the market’s inability to hold up in the stronger years of the four-year electoral cycle, when presidents are running for reelection and do everything they can to boost the economy and markets.

The interesting fact of the recent low was that it closed just below the 2006 closing low of 10,667. So the market’s reaction is certainly more encouraging this time, but we’d note that the more important support level this time around is the 2010 midterm year low of 9686. That will be the critical support level for the market for the next couple of years. If it holds until 2014, the next midterm year, it would be a constructive longer-term sign for the stock market and the economy. If it breaks prematurely, it would be a sign that the financial overhang of 2008 is still very much with us and that Fed policy remains inadequate against the forces of deleveraging.

Paul Shread is a Chartered Market Technician and co-author of the book “Dow Theory Unplugged: Charles Dow’s Original Editorials and Their Relevance Today” from W&A Publishing.

Dow Theory Gets Tested

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Now looks like a good time to revisit the recent apparent Dow Theory sell signal.

With the Dow approaching its breakdown point of 11,865, the bulls’ resolve could get tested, particularly with a seasonally weak six weeks ahead of us. But a strong move above that level could be the first sign that the bears are losing control.

As we noted earlier this month, major bear markets are rare if the NYSE advance-decline line tops out at the same time as the market, as happened earlier this summer. How rare? We can find only two bear markets – 20-25% declines in 1946 and 1977 – where the NYSE A-D line didn’t top out before the market, in data going back to 1926. (Thanks to Tom McClellan for help researching that.)

Sentiment is turning market-positive here, with Investors Intelligence bears on the rise and commercial future traders long the big S&P contract.

But with September and October still ahead, caution would be wise for now.

Paul Shread is a Chartered Market Technician and co-author of the book “Dow Theory Unplugged: Charles Dow’s Original Editorials and Their Relevance Today” from W&A Publishing.

Dow Theory Turns Wobbly

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Plenty of smart people are calling the recent action in the Industrials and Transports a Dow Theory sell signal, but we’ll hold off for two reasons: last month’s new bull market highs in both the Transports and the NYSE advance-decline line (see charts below).

Dow Transports

NYSE advance-decline line

I look for persistent new trends in both the Industrials and Transports before calling a major trend change, and last month’s new bull market high in the Transports means the index still needs a four-week rally followed by a new closing low to confirm the Dow’s bear signal. I look for 18 trading days for an intermediate-term move, so an 18-day rally followed by a new closing low would do it. Some who see this as a Dow Theory sell signal are calling the top in the Transports a “line,” or trading range, which the index broke down out of. That view has some historical legitimacy, although it’s a pattern the market hasn’t seen in recent decades.

Still, it’s hard to see this becoming a major bear market when most NYSE stocks continued to gain right into the top; that suggests that there may be enough liquidity to limit the decline. As Paul Desmond of Lowry Research noted in a 2006 paper, market internals tend to erode before the top if a major bear market is going to occur.

That said, the market is quite ugly here, but all the pieces aren’t quite in place yet to declare it a bear market.

Paul Shread is a Chartered Market Technician (CMT) and co-author of the book “Dow Theory Unplugged: Charles Dow’s Original Editorials and Their Relevance Today” from W&A Publishing.

Dow Theory Defined

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By Paul Shread, CMT

Dow Theory might just be the most misused and misunderstood of any technical analysis theory, so I thought it would be useful to offer a simple definition of this most important stock market trading system.

First, it’s helpful to understand that Dow Theory was initially an economic theory developed in the pages of the Wall Street Journal by Charles Dow from 1899 to 1902. Dow’s theory was simple: if goods were being produced and moving through the economy, then it should show up in the action of both the Industrials and Transports, the makers and transporters of raw and finished products. If either the Industrials or the Transports weren’t confirming the direction of the other, then it was a warning that conditions might be about to change. And if both were headed substantially south, then the economy was likely to follow.

Simple enough, but a lot of trees have been felled trying to define when a Dow Theory trend change occurs. Dow and his followers, William Peter Hamilton and Robert Rhea, took the general view that a trend change occurred when one or both indexes failed to take out a previous high or low in the prevailing trend and then set a significant low or high in a new direction, signaling a trend change.

Every trend change begins with a correction against the prevailing trend; a trend change occurs when that correction resumes after a break and produces a new extreme in the new direction. So here’s the basic pattern when a bull market turns to bear: a correction, then a rally that fails to eclipse the old highs by one or both indexes, followed by new lows (Dow always used daily closing prices to define new highs and lows). Turning from bear to bull, the pattern would be a rally, a correction that failed to produce new lows in one or both indexes, and then another rally that took out the closing highs of the last rally.

The sticking point among Dow Theorists has been how to define those significant corrections that can mark the start of a new trend. The general rule of thumb has been a one-third to two-thirds correction of the previous major move over a period of three weeks to three months; basically, an intermediate-term correction. The Dow Theorist would then look for a countermove of the same depth and duration, followed by a new extreme in the new direction, before calling a trend change. But what appears to be a hard and fast rule often falls apart in reality: How would you classify a correction that retraced a quarter of the previous move over four months, or retraced most of the previous move in two weeks? That’s where Dow Theory has often been subject to uncertainty, judgment calls and lack of unanimity.

A second issue in calling major turns is Dow’s idea of a “line,” which is an intermediate-term trading range in one or both indexes. A break out of those trading ranges by both indexes is also considered significant, particularly if the breakout is simultaneous.

A Dow Theory Trading System That Has Stood the Test of Time

So with all that as background, here’s the one Dow Theory definition that seems to have performed best over time, that of Martin Pring, author of the basic TA text “Technical Analysis Explained.” Pring focuses on time rather than price; he looks for a correction that retraces a third or more of the time of the previous move, looking for a minimum correction of one month. He ignores price entirely. He also wants both indexes to fail to make new highs or lows after that correction (no “negative divergences” where only one index fails to eclipse a previous extreme while the other one does), and then both indexes confirm the new trend with new closing extremes in the new direction.

With “lines,” Pring also looks for a trading range of at least a month.

How has this performed over time? Using the data in Pring’s book from the 1966 stock market top to the present, that approach has averaged about 13% a year, a few percentage points better than the market as a whole. Over time, that adds up, plus it also has the advantage of sidestepping the steep drawdowns of bear markets. Only once has Pring’s approach been really wrong; it sat out or was short a 32% rally in 1949. It has otherwise been right about 80% to 90% of the time, with losses of 1% to 7% when wrong.

So why does Pring’s system work so well? Here’s one possible explanation: Because trends tend to last longer than anyone anticipates, Pring’s system keeps investors on the right side of the major trend longer and avoids whipsaws. One of the criticisms of Dow Theory is that it is slow to recognize and acknowledge trend changes; that could also be viewed as a strength, as major trend changes are rare occurrences. There have been just three Dow Theory signals in recent years by this system: a buy signal in June 2003, a sell signal in January 2008, and a buy signal in July 2009. Load up on value stocks (like low PE and price to sales and high free cash flow) during bull markets, go fishing and sleep soundly at night. You’ll leave money on the table at the start and end of bull markets, but that sacrifice has paid off over time by keeping you on the side of the major trend as long as possible. Dow Theory follows the major trend; it doesn’t try to call tops or bottoms until some time after they’ve occurred.

If Pring’s system seems too complicated, it could be modified further. Instead of looking for a one-third to two-thirds time retracement of the previous move, simply look for a one-month correction, regardless of how deep it is (remember, use daily closing prices). Even one month could be vague, so call it 18 trading days, a number based on my own unscientific observation; that would eliminate judgment calls entirely. Here’s how that would work when going from bull to bear: New highs, a one-month or longer correction, a one-month or longer rally, and then new closing lows by both indexes. Reverse the process when going from bear to bull. The indexes do not have to do this at the same time; one will often complete a trend change weeks or months ahead of the other.

One example: A few Dow Theorists had the 2010 correction as a Dow Theory sell signal, but Pring did not. Here’s why: The June rally in the Dow and Transports was less than two weeks long, far too short to qualify as an intermediate-term move, so the low in the initial leg down didn’t occur until early July (see charts below). The one-month rally that occurred off the early July low was long enough to qualify as an intermediate-term move, but as the indexes did not go on to set new lows in the August pullback, there was no sell signal. The charts also show why Pring’s system works so well: If you’d called the late June sell-off a Dow Theory sell signal, you would have sold out at 9800 in late June and bought back at 10,700 in late September.

Dow Jones Industrial Average 2010

Dow Jones Industrial Average 2010

Dow Transports 2010

Dow Transports 2010

And finally, one last pet peeve. Dow Theory has been shown to work on much shorter time frames (although perhaps not as consistently), but that doesn’t make it Dow Theory. Every week some article appears in the financial press about how important it is to Dow Theory for both indexes to eclipse X level that was set on a certain date. That’s not Dow Theory, which is about the slow transition of the stock market — and the economy — from bull to bear and bear to bull.

Paul Shread is a Chartered Market Technician and co-author of the book “Dow Theory Unplugged: Charles Dow’s Original Editorials and Their Relevance Today” from W&A Publishing.