More terrific follow up on the Dow changes, courtesy of Briefing.com:

Dow Theory

Traditional Dow Theory was not developed by Charles Dow, however. Dow Theory was largely developed by others in the 1920s and 1930s. Two of the principle books that outlined traditional Dow Theory at the time include:

  • The Stock Market Barometer William Hamilton, 1922
  • The Dow Theory Robert Rhea, 1932

Traditional Dow Theory was based on the idea that the three basic indexes: industrials, transportation, and utilities provided an accurate reading of the core elements of the US economy. Since stock prices presage actual economic growth in a company, analyzing movements in the three basic indexes could provide meaningful clues as the direction of the overall economy.

The essential elements of "traditional" Dow Theory can be summarized as follows:

  • Stock prices closely represent the near-term future of the economic health of the companies. Rising prices indicate reasonable expectations of near-term growth.
  • The summation of stock prices of similar companies closely represent the near-term future of a particular industry.
  • The industrial companies represent "final product" that is consumed by either business or individuals.
  • Industrial companies "consume" materials. (Factories need supplies.)
  • When industrial companies begin consuming more, it means that they are seeing higher levels of orders for finished products – which implies economic growth is happening.
  • A leading indicator of material-consumption by industrial companies can be seen in the transportation and utility indexes. When factories order more supplies, the raw materials must be shipped to the company – on railroads. In addition, the factory will begin consuming more electricity, coal, or oil – all sold by utility companies.

It should be remembered that Dow Theory was developed in an era where there were few "analysts" and almost no government economic measures. Compared to today’s information flow, most investors were flying blind most of the time. Because of this, Dow Theory was extremely popular in the pre-WWII era.

Using Dow Theory

What Dow Theory all boiled down to is:

  • Look for rises in the transportation and utility indexes – ahead of a rise in the industrial index.
  • When it happens: Buy the industrials.

The theory could also be used to forecast coming economic declines.

By following trends in each of the three indexes and looking for the relative movements among them, a reading of the market direction could be developed. Over the years, Dow theory become quite detailed with a whole jargon of its own.

In addition, numerous "enhancements" and "improvements" have been added by various people, some which had the effect of altering the basic idea of "reading the economic tea-leaves."

Traditional Dow Theory was actually quite successful, or at least was proclaimed to be, during the pre-war era of the market.

It should be remembered, also, that traditional Dow Theory was the only strategy that correctly predicted the market crash of 1987 a full two weeks ahead of the actual crash. Whether the theory logically predicted the crash based upon the principles behind it or whether the "tea-leaves" just accidentally aligned before mid-October 1987 is still debated (occasionally).

Dow Theory Dead

Dow Theory can be officially pronounced dead, although discussions of its "ill-health" have circulated for years.

With today’s changes, there is nothing industrial about the overall composition of the index.

The following table summarizes this point.

Type of industry Stocks in DJ Industrials Market Capitalization %
Total Dow 30 100%
No significant physical goods produced – no requirements for "raw materials" to be shipped 7 31 %
No significant increased consumption of utilities when business improves 15 66%
True "industrials" whose supplies and utility consumption is reasonable correlated with increased business. 12 28%

Some stocks use neither raw materials nor increased utilities when business improves, such as J.P. Morgan. General Electric is clearly a manufacturer, but with one-third of profits coming from financial services, it is hard to classify the company as an "industrial" company.

What Now?

The table above shows there is no longer any relationship between the 30 members of the Dow Jones Industrial Average and true "industrial production." What we really need is an "information index" that more accurately reflects the direction of the US economy.

Technical analysis of Dow average charts will likely continue. However, because the Dow Jones Averages are "price-weighted" and not "market-capitalization" weighted, they are, in our opinion, inaccurate measures as a wealth index.

Nevertheless, old traditions take centuries to die.

The answer to the question "how did the market do today?" will still most likely be answered the way it has been for 100 years: "

Category: Finance

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

2 Responses to “Is “Dow Theory” Dead?”

  1. Mike Johnson says:

    Barry,

    As I was creating a very frustrating “DO-IT-YOURSELF” Blog for my website today, my research brought me to yours. The topic I ran into was Dow Theory. So, what the heck, I’ll bite. Below is the one and only post on my new BLOG. But first, to my larger point for contacting you – HELP. I see that your blog has been created by the same company that I subscribe to (Your Blog is nicely done), so would I be correct in assuming that it was a do-it-yourself number? If so, could I chew your ear a bit and get some help setting mine up? FYI I read your bio, so I’ll understand if you are too busy.

    PS I won’t tell Richard you said Dow Theory is DEAD, should you agree with Briefing.com!

    Awaiting The Transports

    With each new gush up in oil prices, the Dow Jones Transportation Index is slowly cracking. The real damage likely will not begin until they close below 2,750. Though, as they approach we may get a pedal to the metal approach from the holders of the plains, trains, and truckers index. Would Charles Dow be proud today, that a good many investors still place importance on the first index he ever created? I think the question is well worth the debate. The relevance of Dow Theory is constantly questioned, terribly misunderstood in the general financial media, and has been deserted by the newspaper (Wall St. Journal) founded by the man credited with penning the theory’s implications. Periodically the theory is grudgingly acclaimed for its inherent low-volitility, and recently, it would be hard to argue that Dow Theory nailed the two most important moves of the last twenty-four months. The March 2003 retest of the October 2002 lows, and the January 2004 Transports warning which has turned out to be a fortunate warning.

    Chart -

    http://dowtheory.blogs.com/template/images/Non-confirmation.html

  2. richard russell board says:

    how can I get access to the temporary BB for RR as I have seen advertised http://www.dowtheory.blogs.com doesn t work thank you in adance rgds vkb