The Dow Report: Dogs of the Dow - Part II
By Tim W Wood CPA, February 25, 2005
Last week we set up a model portfolio using Michael O'Higgins' Book Value method. This week we are going to set up another Dogs of the Dow model portfolio using the Dividend method. This method is widely used and is aimed at picking high dividend paying stocks. For this method we look at the 30 stocks that make up the Dow Jones Industrial Average and simply pick the 10 stocks with the highest dividend yields. This becomes our model portfolio for the entire year. This portfolio is then adjusted at yearend for the next year. Ideally, we should have set this portfolio up on January 1, 2005 and used the closing prices for 2004. But, since we didn't set the portfolio up at that time and because I want to be consistent, so that we can compare the Dividend method to the Book Value method, we will use the closing data as of February 18, 2005.
Under the Dividend method our 2005 portfolio will consist of the following stocks.
|Merck & Co||32.61|
The purpose of tracking this model portfolio is multifold. One, we want to compare the performance of the Book value method to that of the Dividend method. Two, we want to compare both of these methods to the performance of the Dow Jones Industrial Average. Three, if the slide into Phase II of the bear market, according to Dow theory, begins in 2005 we want to see how these methods perform in that environment as well.
Now for a quick look at the market. Below is a daily chart of the Industrials and the Transports. In 2004 the story was that the Industrials were lagging the Transports. Now the shoe is on the other foot and the Transports are lagging the Industrials. According to Dow theory the markets are clearly not in gear. We know from our studies of the past that when the averages are not in agreement they are warning us to be careful because trouble likely lies ahead.
Non-confirmations are not to be confused with buy or sell signals. Buy and Sell signals under Dow theory are another story for another time that I may just cover in a future report. What I want you to understand about Dow theory is that these non-confirmations are warnings that should be taken seriously. The problem with non-confirmations is that they can continue for what seems to be forever. As I said above, in 2004 we had the non-confirmation with the Transports being the leading average and now it’s the Industrials. These extended back and forth non-confirmations tend to put people to sleep. People begin to discount them and think that the Dow theory is broken or that this time is different, so the Dow theory no longer works. I can assure you that this is indeed erroneous thinking. The averages are screaming to those who understand and believe in the Dow theory. It is greed and lust to see the performance from the 1990's that deafens people.
Let me remind you of another non-confirmation that was ignored by those who either did not understand or did not respect the Dow theory. We have looked at this before, but it is time to look at it again. Below is a chart showing the 2000 top.
I have marked the non-confirmation that occurred at that top. The market finally broke hard into March 2000.
I know that most people have forgotten it, but there were some 3 and 400 point down days in that decline and the market went from a high of 11,750 to 9,700.
Then, the market went sideways for the rest of the year. Everyone thought that the worst was over. Those who understood and respected the Dow theory knew better and my cycles work also warned of the continued trouble ahead.
But, I can still remember the hype stories on the news about how great the economy was and that the Dow was going to 36,000. The end result was that the Dow theory non-confirmation at the 2000 top was followed by the Phase I decline of this bear market, which ultimately took the Industrials down some 38%.
Today we have the Transports that are thus far lagging the most recent run by the Industrials.
We also have the longer term Dow theory non-confirmation from the 2000 bull market top shown in the chart below.
Here are a few quotes on the subject from the great Dow theorist Robert Rhea:
"It is not necessary for the Rails and the Industrials to confirm each other in extent of the movement, nor is it required that they confirm in duration; nevertheless, while we may disregard the extent of a rally (or decline), and while we may ignore, to a degree, the time required for a movement, it is necessary for these formations to confirm each other, both in direction and in the penetration of preceding critical high or low points, before the movement can be taken as having any authority of forecast."
"A wise man lets the market alone when the averages disagree."
"When the averages disagree, they are shouting be careful."
I have studied the Dow theory in great detail. I have read and studied the writings of Dow, Hamilton, Rhea and Schaefer. I know what they would be saying and I'm not going to bet against over 100 years of Dow theory history. If you choose to, you are doing so at great risk.
Tim W. Wood
© 2005 Tim Wood