Reflections and Practical Applications of Dow Theory

by Martin Goldberg CMT. November 6, 2003

The Dow Theory is the oldest and the most well know technical theory used for determining and investing with the long-term trend of the stock market. But many stock market experts believe that the Dow Theory is no longer relevant. They back up their belief with its underperformance versus other methods over the last 10-plus years. I think that the concept of "confirmation", which is the basis for the Dow Theory is still sound; although strict interpretation of the Dow Theory applied only to the Industrial and Transport sectors may no longer be relevant in today's economy. This is because of the overall shift of the US from an industrial to a service economy. In this article, I present a brief description of the Dow Theory, and provide two practical applications of Dow Theory principles applied in an alternate, yet practical way.

The analyses presented in this article indicate that the apparent long-term "new" bull market is suspect, and the latest move in homebuilders stocks is ominous.

Overview of Dow Theory

The first part of the Dow Theory is basic. There are three types of stock market movements. A primary or secular trend which takes place over the course of years. There are secondary or correction movements, which take place from weeks to months. These run contrary to the primary trend. There are day-to-day fluctuations, which can move in either direction (bull or bear), and are of no particular importance (except to day traders). The overall objective of Dow Theory is to determine and invest with the primary trend.

The second part of the Dow Theory is that the Dow Jones Industrial Average and the Transportation Average must corroborate or confirm each other's direction for there to be a reliable market trend. When movements of several weeks or longer take place and are confined to a range of about 5%, this is known as a trading range. According to the Theory, when both averages break out above this range, prices should head higher. When both averages break down below this line, prices should head lower. If one average breaks out and the other doesn't, the move is said to be inconclusive. Such unconfirmed moves in an average are suspect and may be considered false, until confirmed by the other index.

The logic behind the original Dow Theory is that both the industrials and the transports are independent of each other. Yet, for the industrials to get their product to market, they must use the transports. When the industrials are doing well, the transports should also do well. However, when one sector is doing substantially better than the other, a divergence is taking place. This demonstrates that one sector is much stronger than the other; and if it continues, without the other sector catching up, a major reversal in the market will take place. For the confirmation to take place, it isn't necessary for both averages to cross at the same time. However, the one should then follow the other before the first average crossing pulls back across the former trading range.

Criticism of Dow Theory

W.H.C. Bassetti, the editor and co-author of Technical Analysis of Stock Trends, 8^th edition, says that the Dow Theory is no longer adequate to predict the primary trend of the stock market. His argument is based on the greater amount of complexity in today's economy compared to when the original Dow Theory was established at the turn of the 20^th century. He offers an alternative to the Industrial and Transport confirmation, which is to utilize the Dow, S&P, and NASDAQ averages together instead of the Dow Industrials and Transports. He says, that when all of these three averages agree in the direction of their (up) trends, "Bulls may assume to be safe in general…"

I disagree with Mr. Bassetti's suggestion of using the three averages together to determine the long-term trend of the market. One of the strengths of the Dow Theory is that the Dow Industrial and Transports are independent indices; the Dow, S&P and NASDAQ are not /independent. There are many common components in two indices or all three indices. A false move in a few high-proportion sectors could produce a false "confirmation" in several indices. The chart below illustrates the large proportion (39%) of S&P 500 index capitalization that consists of information technology, plus financial companies. Similar conditions exist for the Dow, which is 31% tech and financials, and (especially) the NASDAQ. A major move in a couple of sectors such as technology and financials (as we are seeing now) could skew Bassetti's Dow Theory analysis and result in a false confirmation of a primary bull market.

Examples

I think that the principle of two independent but related sectors (Dow Industrials and Transports in the original Dow Theory) is still a valuable tool that can be used to help establish whether movements in an independent sector are either real or false. If confirmation occurs (as indicated by the stock movement of the corresponding sector), the movement can be "trusted"; but if confirmation does not occur, then the move of the advancing independent sector is suspect. I will provide two such applications in the current market. Example 1 applies to the overall market through use of the stocks in the Dow Jones Industrial Average (DJIA). Example 2 applies to a specific portion of the economy - homebuilders and furnishers. I believe that the strength of my analysis is that in both examples, the confirming indices are independent; but as with Industrials and Transports of the past, the confirming industries depend on one another. Is my method correct for these specific examples? As with any technical analysis, only time will tell.

Example 1 - Dow Theory Applied to Dow Jones Industrial (DJI) Technology and Financials (DJITe+F) Versus DJI Non-Technology and Non-Financials (DJI No Te or F)

For this example I will apply Dow Theory to stock categories in the same way that Dow Theory is applied to the DJIA and DJ Transports. The DJI Technology and Financials consist of Microsoft (MSFT), IBM, Hewlett Packard (HPQ), Intel (INTC), American Express (AXP), JP Morgan (JPM), and Citigroup (C). The Non-Financials consist of the remaining stocks comprising the remaining 23 companies in the Dow Jones Industrial Average (DJIA).

The chart below shows a long-term graph of the DJITe&F:

As you can see, when considering the Dow Technology and Financials only, the trend long term-down trend appears to have been broken. However, proper application of Dow Theory would suggest that the other industrials would have to confirm the broken downtrend.

The graph below is a long-term chart of the remaining non-Technology and Financial Dow Industrial Stocks:

Whereas the down trend has been broken for the combined tech and financials, the downtrend for the other remaining Dow Jones Industrials has not been broken and is still very much intact. Dow theory applied to these categories would suggest that confirmation has not occurred. This would suggest that the move in technology and financial stocks is suspect. Strict application of Dow Theory (except for my category switches) suggests that it is too early to buy until the non-tech and financials confirm the broken downtrend.

One could argue that my selection of technology and financials to analyze separately (similar to the transports) is simply selectively removing the leading sectors of the market rally. However, you might consider technology in the New Economy to be analogous to the Industrials in the Old Economy. Today capital and operating spending in technology are needed to support a healthy overall economy. In the past, capital and operating spending in the overall economy were needed to support a healthy transport sector. In the case of the financial stocks, the relationship is less direct. Financial stocks can be propped up for awhile by excessive credit and a surging stock market (for example, through high share turnover and investment banking deals). But sustainable success in financial stocks can only be achieved by a healthy overall economy. Even though the economic data from the government indicates capital spending and the overall economy is "picking up", the lack of confirmation in the charts of the Dow stocks indicates that the market may be saying otherwise.

The evidence suggested through application of Dow Theory to Technology and Financial stocks versus the remaining Dow Industrials suggest that the long-term trend of the overall stock market shows no long-term "new bull market". The current bull move in the market appears to be a secondary move, until confirmed to be otherwise by the remaining Dow Industrials.

Example 2 - Homebuilding Versus Home Furnishing Indices

Example 2 presents an application of the Dow Theory to two related stock indices - Homebuilding and Home Furnishing stocks. Fundamentally, these two indices should track each other over a long period of time. The relationship is similar to the old economy relationship between the industrials and transports. The chart below shows the long-term price trends of these two sectors dating from January of 1978 to the present. The chart indicates that from 1978 to the 2^nd quarter of 1998 they did follow a similar "silhouette."

Also, the two indices generally maintained the same direction from mid-1998 to recently. However although the general directions of the two indices were the same since the second quarter of 1998, the home furnishing sector has faltered by tracing lower "highs", and generally lower "lows". In contrast, Homebuilders have continued to make higher highs and higher lows.

I indicated the Dow "theoretical" buy and sell points of the Home Furnishing index by green (buy) and red (sell) dots on the chart, above. The method would have worked pretty well from 1978 to 1998. From 1998 until recently the method would have not worked as well. Its use would have kept investors from several plunges in the Home Furnishing Index, but would have kept them from enjoying several high peaks.

The one-year chart below of the two related sectors paints an ominous Dow Theory picture for homebuilding stocks, even as they continue to soar.

As you can see, the latest bull move for the homebuilders was not confirmed. In fact, it appears to have been decisively refuted by the home furnishers! Fundamentally, this would suggest that today's homebuyers are extending their purchases to a point to where they cannot furnish the newly mortgaged homes. The lack of confirmation in the home furnishers index suggests that homebuilders' customers are now stretched to just make settlement. It appears that the high quality buyers have already settled and the buyer pool is comprised of those who can barely afford to move in. The demand side of the supply/demand equation is likely to lessen as the financial quality pool of potential buyers continues to lessen. Accordingly, the bull move in homebuilders is probably unsustainable. Should interest rates rise substantially, the demand will fall and impact homebuilders. This is an ominous sign for the homebuilding stocks.

I think the summary table below is also very telling. Home furnishers are suddenly having a difficult time. Can the homebuilder's difficulties be far off?

Companies Comprising Home Furnishings and Fixtures Category

Symbol	Company Name	Recent Events
BSET	Bassett Furniture Ind.	9/25/03 Sales down 5% due to decrease from J.C. Penney's.
BSH	Bush Industries, Inc.	10/13/03 Announces expectations for 3Q at the low end of guidance.
CALA	Catalina Lighting, Inc.	10/10/03 No releases. Downgraded by Stephens, Inc.
CRC	Chromcraft Revington, Inc.	10/29/03 Reports higher earnings on 9% sales decrease due to share buy back.
DMIF	DMI Furniture, Inc.	10/23/03 Secondary offering at $5.50/share. Stock closed at $6.25 Friday.
ETH	Ethan Allen Interiors Inc	10/15/03 Sales up 2.9%; earnings flat versus last year.
FBN	Furniture Brands International	10/31/03 Closing division. Struggling with foreign competition and excess capacity. Lowered earnings guidance.
FLXS	Flexsteel Industries, Inc.	10/22/03 Expects earnings of $0.26 to $0.31in 1Q. EPS $0.29 last year. No growth. Acquisition.
HOFT	Hooker Furniture Corporation	10/17/03 CEO upbeat. 40% sales from foreign production.
HUB.A/B	Hubbell Inc A	10/21/03 3Q revenue 2.6%. Company expects weakness to continue in 2004.
JUNO	Juno Lighting, Inc.	10/9/03 Moody's revises outlook to negative. Share repurchase announced. No insider buying indicated.
KBALB	Kimball International	10/28/03 Sales down in both segments.
LEG	Leggett & Platt, Inc.	10/15/03 Profit down, cuts outlook.
LZB	La-Z-Boy Incorporated	10/10/03 Cuts forecast. Shares fall. CEO says strong retail trend following Labor Day did not continue.
NTZ	Natuzzi, S.p.A (ADR)	09/03/03 Unit Sales up 0.6%. Net profit margin at 5.9% versus 13.7% in previous quarter.
STLY	Stanley Furniture Co.	10/13/03 Sales up 6%. Profit down 10%.
TII	Thomas Industries Inc.	10/24/03 Sales up profit up on sales of Automotive pumps and compressors.

Source note: Index components from Microsoft Money.

Summary/Conclusions

Although strict use of Dow Theory is somewhat outdated by the US' conversion from an industrial to a service economy, the use of related independent indices may allow us to apply Dow Theory in an alternate yet practical way. The analyses presented in this article indicate that the apparent new bull market is suspect. It is too dependent on technology stocks and financials. The related industrials are still near the top of a well-defined downtrend. Until confirmed, we have no new bull market. Similarly, since the Home Furnishing index has refuted the latest bull move in the Homebuilders, this is an ominous sign for the Homebuilding stocks.

Notes: Chart data plotted based on data from Microsoft Money. Homebuilders and home furnishers index data from Microsoft Money. Recent company events summarized in the table by the author from Yahoo Finance information.

Today's Market

There was a "hat-trick" of positive news today that would have frightened market bears:

Nice talk out of Cisco Systems, a company that had a year-over-year (y-o-y) sales growth rate of 6%, which is 1.5% less than the reported growth in gross domestic product (GDP).
The usual infusion of positive economic data from the government (weekly jobless and productivity).
Mid-day happy chirping from Alan Greenspan.

Wall Street loved the Cisco news as there were two analyst upgrades today. The World Series on Fox ended last month, but from the after-market interview of Cisco CEO John Chambers, it seems that the softball season is extending into November at CNBC.

With all of this good news, what did the stock market do? The Dow was up 0.37%, the S&P 500 was up 0.59%, and the NASDAQ was up 0.87%. Trading was heavy all week and today was no exception.

Gold was down because Fed Chairman Greenspan said something. Silver stocks are not acting right. The 10-year note was down. This hurts the investment valuations of companies that have earnings. Stocks with only promises are largely unaffected by interest rates. Of course, this too was reflected in the market action today where NASDAQ led.

Wait a minute! May be I am wrong. May be this is sustainable. May be we can continuously refinance continuously rapid-appreciating houses to sustain growing levels of consumption.

May be we can continuously buy and sell overpriced and rising technology shares to each other for a very long time to come. It worked in 1999 and 2000 didn't it?

There will be more positive economic data tomorrow. Have a great evening!

Martin Goldberg

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