Charles Dow's Original Editorials and Their Relevance Today

Archive for the ‘Dow Theory’ Category

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 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.

How the stock market escaped its most dangerous period without a bear market

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By Paul Shread, CMT
The stock market managed to make it through the weakest part of the four-year cycle without a bear market — and a single indicator could be the biggest reason for that.

The NYSE advance-decline line never broke down this year as it did in 2007. In fact, it continually made new highs this summer even as the stock market was slow to recover (see chart below). If the market has broad-based strength, it’s hard for sell-offs to become much more than garden-variety corrections.

NYSE

Compare that to October 2007, when the advance-decline line made a lower high as the major indexes hit new highs (see chart below). There was no such negative divergence this time.
NYSE

The current Dow Theory signal remains the buy signal from June 2009. Some called the cycle of lower highs and lower lows set by the Dow and Transports this summer a sell signal, but the June rally in the indexes wasn’t long enough to count as an intermediate term move (see charts below).

Dow Transports 2010

Dow Transports 2010

Dow Jones Industrial Average 2010

Dow Jones Industrial Average 2010

Martin Pring, author of “Technical Analysis Explained,” takes the view that a reaction should be at least a month in duration, so there was no Dow Theory sell signal on the subsequent new lows in July. Pring’s conservative approach to Dow Theory works well, so his rules bear restating here: Both the Industrials and Transports must confirm a new trend with an intermediate move in a new direction followed by a one-month reaction and then new highs or lows in the new direction. Simple but effective.

We are now entering the strongest part of the four-year cycle for stocks, so stocks should be able to avoid significant weakness over the coming months. However, it’s not clear if sentiment will allow significant upside from here. The weekly Investors Intelligence survey, which has provided reliable sentiment data for 40 years, is showing a high level of bullishness already (45-24 bulls to bears), so the market may have already seen a good portion of its rally off the midterm election year low that was likely set in early July.

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.

Welcome to Dow Theory Unplugged

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Dow Theory Unplugged book

Dow Theory Unplugged

Dow Theory Unplugged: Charles Dow’s Original Editorials and Their Relevance Today is the most complete collection of Charles Dow’s original writing ever assembled. Dow Theory is widely credited as the basis for modern technical analysis. Yet its origins, Charles Dow’s original writings, have been all but forgotten. Dow Theory Unplugged contains a critical selection of 220 original Wall Street Journal columns from more than one hundred years ago, the raw material that led to the development of Dow Theory and remains relevant for the twenty-first-century trader.

In addition, top Dow Theorists, including Richard Russell, Charles Carlson and Paul Shread, CMT, contribute modern-day analysis to help you apply Dow principles to your trading practice today.

Charles Dow understood the markets better than anyone in his own time, and perhaps any time since. As co-founder of the Wall Street Journal and the Dow Jones Indexes, he developed the framework for monitoring market movement that we have been using for the last century. Dow also wrote hundreds of columns in the Journal outlining a groundbreaking market strategy that became the first chart-following systematic approach to investing.

Dow’s columns are reprinted here as they originally appeared in the Journal and organized by topic around the six modern-day tenets of Dow Theory:

  • The averages must confirm each other.
  • The averages discount everything.
  • The market has three trends.
  • Major trends have three phases.
  • Volume must confirm the trend.
  • A trend continues until signals reverse.

Market movements are really a reflection of human nature on a massive scale. And Dow was as astute a judge of human nature as they come. Taking in Dow’s editorials can help you see your trading from a new perspective, from the original master of technical analysis.