The Dow Theory: Yes, It Is Still Relevant
By Tim W Wood CPA, October 1, 2004
In recent weeks I have been seeing numerous misquotes and misinterpretations on Dow Theory. One article quoted a couple of guys who were saying, under Dow theory the market conditions are currently bullish. In the same article one of the guys says that the primary bull market will be reconfirmed if the Industrials move above 10,737. In yet another article that someone sent me, the author states that the current non-confirmation between the Industrials and the Transports is actually bullish. This author goes on to say that this may have been the way things worked in the twentieth century, but now that we are in a new century everything is different and that the traditional interpretation of Dow Theory is wrong.
I have been asked by many to explain my view on the comments above. So, let me begin by saying that I have gone to great lengths to find as many of the original writings by the great Dow theorists of the past. These writings include Charles H. Dow, William Peter Hamilton, Robert Rhea and George Schaefer. Among these pioneers of the Dow Theory, I have found more material by Robert Rhea than any of the others mentioned above. I have studied all of these writings in great detail for years. I have found that the interpretations by each of these great Dow theorists have been consistent and that each has kept the theory pure. I have absolutely no doubt about the current market conditions nor the correct interpretation of current market conditions under the Dow Theory.
According to Dow Theory, both bull and bear markets unfold in three phases. (Identifying these phases is much more involved and is outside of the scope of this article.) In the current case the Dow Theory triggered a sell signal back in September 1999 in the third and final phase of the late great bull market. This makes that sell signal a "Master" signal, which overrides any and all secondary signals. Once this signal was confirmed in 2000 the primary trend of the market became established as being down. Once the primary trend is established, the market is assumed to remain in that trend until the primary trend is reversed. According to Dow Theory the PRIMARY trend is still DOWN. Furthermore, we are still operating under the 1999/2000 confirmed "Master" sell signal.
In June 2003 the Industrials did move above its previous secondary reaction high point. This move was further confirmed by the Transports. Many have misinterpreted this as a Dow Theory buy signal. In reality this was a Dow Theory buy signal, but it was of secondary importance. In other words, it was a buy signal that is subordinate to the 1999/2000 "Master" sell signal. I believe that this is where many have misinterpreted the Dow Theory as currently being bullish. But, even this secondary buy signal was invalidated on March 10, 2004 when a secondary Dow Theory sell signal was triggered. Today we remain under both the "Master" sell signal as well as the secondary sell signal. According to the pure interpretation of Dow Theory, we do in fact remain under a sell signal.
The next issue is the misinterpretation that the current "bull market" will be reconfirmed if the market moves above 10,737. Well, since we are not currently in a bull market it certainly will not be reconfirmed with a move above 10,737. Remember, we are still operating under the "Master" Dow Theory sell signal and the Primary trend is still down. The rally out of the October 2002 low is not a bull market, but rather the very important rally that historically occurs and separates Phase I of a bear market from Phase II. Under Dow theory secondary buy signals could be triggered prior 10,737. A rally above 10,737 would serve to reconfirm another secondary Dow Theory buy signal. However, these buy signals would still be subordinate to the "Master" sell signal and it is for that reason that it would be considered a secondary signal. Understand that I am not suggesting that we should discount these secondary signals because such action would be bullish. But, what I am saying is that we must put these signals in the proper context according to Dow theory and understand that they do have a hierarchy.
This brings us to the current non-confirmation. For this I want to share a few quotes with you.
William Peter Hamilton - "The movement of both the railroad and industrial stock averages should always be considered together. The movement of one price average must be confirmed by the other before reliable inferences may be drawn. Conclusions based upon the movement of one average, unconfirmed by the other, are almost certain to prove misleading."
William Peter Hamilton - "Dow's theory stipulates for a confirmation of one average by the other. This constantly occurs at the inception of a primary movement, but is anything but consistently present when the market turns for a secondary swing."
William Peter Hamilton - "When one breaks through an old low level without the other, or when one establishes a new high for the short swing, unsupported, the inference is almost invariably deceptive.�
William Peter Hamilton - "Indeed it may be said that a new high or a new low by one of the averages unconfirmed by the other has been invariably deceptive. New high or low points for both have preceded every major movement since the averages were established."
William Peter Hamilton - "The two averages may vary in strength, but they will not vary materially in direction especially in a major movement. Throughout all the years in which both averages have been kept, this rule has proved entirely dependable. It is not only true in the major swings of the market, but it is approximately true of the secondary actions and rallies. It would not be true of the daily fluctuations, and it might be utterly misleading so far as individual stocks are concerned."
Robert Rhea - "The most useful part of the Dow theory, and the part that must never be forgotten for even a day, is the fact that no price movement is worthy of consideration unless the movement is confirmed by both averages."
Robert Rhea - "The Dow theory deals exclusively with the movement of the railroad and industrial stock averages, and any other method would not be Dow's theory as expounded by Hamilton."
I could go on and on with these quotes but it’s really not necessary and I think you get the point. I have also found in my work that these non-confirmations occur at major market junctures. Dow Theory is a proven method for reading the averages and has a track record that is over one hundred years old. Based on my study of Dow's Theory, I have to disagree with the ideal that the traditional interpretation of Dow Theory has changed. If the current picture is truly positive, the traditional method of reading the Dow Theory will give us a buy signal. But, for now this picture does remain bearish according to Dow theory.
Tim W. Wood
© 2004 Tim Wood