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Is “Dow Theory” Dead?

Posted By Barry Ritholtz On April 4, 2004 @ 7:06 am In Finance | Comments Disabled

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: "

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