Charles Dow's Original Editorials and Their Relevance Today

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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 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.