Making Outsized Returns in the Stock
Market - Using the Dow Theory
By Henry To
The Dow Theory
Charles H. Dow
Robert Rhea
E. George Schaefer
Richard Russell
The Dow Theory Today
Charles H. Dow
It is interesting and amazing to note that not until Charles Dow started
compiling the Dow Jones Industrial and Dow Jones Rail Index and started
writing about the stock market a little over a hundred years ago, stock
speculation was regarded merely as a game for the rich or as gambling for
the brave. Sure, there were the tape readers, but the majority of the public
regarded Wall Street as a source of excitement - the entertainment provided
freely (unless you were on the wrong side) by figures such as Cornelius
Vanderbilt, Jay Gould, and the infamous Daniel Drew.
In a series of stunning editorials for the Wall Street Journal at the turn
of the century, Dow laid out the foundation of his own theory on the stock
market. Among them were:
The market is always to be considered as having three movements, all going
on at the same time.
The first thing to consider is the value of the stock in which the
speculator proposes to trade, the second the direction of the main movement,
and the third the direction of the secondary movement (i.e. stocks fluctuate
together, but prices are controlled by values in the long run).
There are three phases to both a primary bull market and a primary bear
market (not to be confused with the three movements mentioned above).
The formation of a "line" in the averages indicates accumulation or
distribution
The market represents a serious well-considered effort on the part of
far-sighted and well-informed men to adjust prices to such values as exist
or which are expected to exist in the not too remote future.
The method of making money in stocks, according to Dow, was to study basic
conditions and exercise enough patience to capture the major movements. One
of the few speculators who discovered this relatively new concept of making
money on Wall Street at the time was Jesse Livermore. He was able to
accomplish this only through trial and error and the making and losing of
several fortunes.
William P. Hamilton
William P. Hamilton, Dow's understudy and the fourth editor of the Wall
Street Journal, continued Dow's legacy after his death in 1903. The Dow
Theory as interpreted by Hamilton forms the basis of all modern technical
analysis today. He wrote about the Dow Theory for the Wall Street Journal
for more than 20 years. His additions to the Theory included:
The Averages discount everything
The primary trend cannot be manipulated
Both the Industrials and Rails (the modern day Transports) must confirm each
other in order for the signal to have authority
The Theory is not infallible. If someone did find such a system, then he
or she will own the world in relatively short order and speculation as we
know it will not exist.
Determining the trend by spotting "higher highs" or "lower lows"
Hamilton's predictions of the trends were uncannily accurate, even as he
developed a wide following from his editorials. A major reason why he was
accurate almost all the time was his lack of a writing schedule - choosing
only to write when he had something to say about the market, sometimes going
for weeks without writing a single word.
The one significant time when he erred was in late 1925 and early 1926 when
he erroneously labeled a serious secondary reaction in a primary bull market
as a bear market. Followers of Hamilton lost heavily during that period, as
the market bottomed out in March 1926 (Industrials 135.20 and Rails 102.41)
and was getting ready to resume its long advance that would not end
(tragically) until September 1929.
Even so, Hamilton would always be remembered for penning the following
editorial on October 25, 1929, just days before the crash. His words proved
prophetic - calling for the beginning of a new primary bear market. Part of
his now-famous editorial is reproduced below:
A Turn in the Tide - October 25, 1929
On the late Charles H. Dow's well known method of reading the stock market
movement from the Dow-Jones averages, the twenty railroad stocks on
Wednesday, October 23 confirmed a bearish indication given by the
industrials two days before. Together the averages gave the signal for a
bear market in stocks after a major bull market with the unprecedented
duration of almost six years. It is noteworthy that Barron's and the
Dow-Jones NEWS service on October 21 pointed out the significance of the
industrial signal, given subsequent confirmation by the railroad average.
Hamilton passed away six weeks after he wrote the above editorial. It is a
tragedy that probably not a great number of people at the Wall Street
Journal or Barron's today have even heard of the Dow Theory, let alone have
a complete understanding of it.
Robert Rhea
The next great Dow theorist, Robert Rhea, initially stumbled upon the
Dow Theory during his endeavor to find "a system" for helping him make money
in the stock market. In his attempts to disprove the theory, he became a
convert. Rhea was a very serious student, and he was able to utilize the Dow
Theory as interpreted by Hamilton to his advantage, buying and holding
stocks in 1921, and basically holding them until late 1928 (he reversed his
short position when he realized Hamilton's advice was incorrect in early
1926), missing only the final blowoff phase. He also "played" the short side
successfully during the subsequent deflation. In 1932, he began publishing
his newsletter based on the Dow Theory, called the "Dow Theory Comment."
Rhea called the bottom of the stock market in July 1932 almost to the exact
day and the subsequent top in 1937. On July 21, 1932, with the Industrials
at 46.50 and the Rails at 16.76, Rhea instructed his broker to tell his
friends "the Dow Theory implied heavy buying for the first time in over
three years." Further, on July 25, 1932, Rhea sent a memo to 50
correspondents, part of which is reproduced below:
The declines of both Rail and Industrial averages between early March and
midsummer were without precedent. The thirty-five year record of the
averages shows a fairly uniform recovery after every major primary action,
and such recoveries average around 50% of the ground lost on the decline;
are seldom less than a third and more than two thirds. Such recovery periods
tend to run to about 40 days, but are sometimes only three weeks - and
occasionally three months.
The time element is in favor of a normal reaction at this time - because the
slideoff was normal (the normal time interval of major declines being about
100 days).
The market gave the unusual picture of hovering near the lows for more than
seven weeks, and might be said to have made a "line" during the latter weeks
of that period.
Because of all these things, and because the volume tended to diminish on
recessions and increase on rallies during the ten days preceding July 21,
almost any one trading on the Dow Theory would have bought stocks on July
19th. Those who did not, had a clean cut signal again on the 21st. Since
that date the implications of the averages have been uniformly bullish, and
it is reasonable to expect that a normal secondary will be completed, even
though the primary trend may not have changed to "bull". So much for the
speculative viewpoint.
Followers of Rhea who bought stocks during that period and held until 1937
made a fortune.
E. George Schaefer
In July 1949, with the Dow Jones Industrials registering a low at 161.60
and with the country in the midst of a severe recession, a new primary bull
market was born. E. George Schaefer, a Dow Theory disciple for more than 20
years, started his newsletter writing career near that time, calling his
subscribers to load up on common stocks in June 1949. He remained
steadfastly bullish in the great corrections of 1953 and 1957 and cautiously
bullish since 1960 until the final top in 1966.
Schaefer believed that Hamilton strayed away from Dow's original principle
of investing in "values" and that Rhea spent most of his life improvising
Hamilton’s "system" of trying to trade the markets when 95% of the
population just cannot duplicate what the emotional-less professional
traders can do. He also emphasized that some of the "rules" that Hamilton
and Rhea developed did not apply to the more modern and more emotional
markets of today (such as the claim that secondary reactions tend to retrace
one-third to two-thirds of the preceding primary swings). The best course of
action was to buy "great values" and staying fully invested through the
primary trend.
In his 1960 book "How I Helped More than 10,000 Investors to Profit in
Stocks," Schaefer stated:
As noted before, my extremely bullish market letters of June and July, 1949,
appeared just a few days and weeks after the low day of 161.60 was
registered on June 13, 1949 by the Dow-Jones Industrials. Since that time,
and for the next 11 years, my letters have been consistently bullish on the
Primary Trend. The stock market has borne me out, and I would say that the
majority of my readers have benefited as they stayed fully-invested in the
way I have counseled.
Schaefer also developed some additional technical tools and made additional
observations along with his study of the Dow Theory. Among them are:
The 50% retracement concept
The yield cycle
The ratio of short interest to daily volume
The study of odd-lot trading
The 200-day investment line (the 200-day simple moving average)
Schaefer turned bearish at the most opportune time in 1966 and became
bullish in gold and gold mining shares shortly afterwards. He was, however,
too early with his bullish calls when he asked his subscribers to buy them
in 1974. Gold immediately proceeded to suffer a huge short-term correction.
The losses may have broken him since he committed suicide shortly
afterwards. From thereon, the Dow Theory torch was passed on to Richard
Russell.
Richard Russell
Richard Russell was another Dow Theorist who stumbled upon the Dow Theory
during a quest to find useful literature regarding the stock market. He
became a convert after reading the writings of Robert Rhea. Russell decided
to follow in the footsteps of Rhea and Schaefer - establishing his
newsletter "Dow Theory Letters" in 1958, partly inspired by the extreme
bearishness of the public during the great correction of late 1957 (Russell
was bullish at the time).
He also urged subscribers to sell at the top in February 1966, and he
rightly turned bullish in December 1974. Following are excerpts from his
newsletter during those periods.
February 10, 1966 (two days after the final top) - While Russell mentioned
that although technical conditions are getting weaker, there is no
indication that the bull market was over yet. However, on the simultaneous
decline of the Dow Jones 40 Bond Average and the Dow Jones Utility Average,
he commented: "In the present ... instance the 40 Bonds turned down in
February, 1965. The real decline in Utilities began in April, 1965.
Therefore, the joint decline in both components can be said to have started
in April, 1965, nine months ago. Based on past history, the decline of
Utilities and Bonds together should be taken as a warning of dangerous
monetary conditions ahead as well as a warning of unsatisfactory stock
market conditions. At very least, the shaded areas identify periods in which
informed investment money is distributing or leaving the market."
Russell began his February 22, 1966 newsletter with the following paragraph:
I dislike emphasizing "the drama of the marketplace" (in contrast with the
cold, analytic approach), but it does seem to me that 1966 is shaping up as
a most exciting year for market students. Not since 1907 has a booming
economy run head-on into a monetary crisis, but I believe there is a
reasonable chance that 1966 will see just that type of situation repeated.
Furthermore, the monetary squeeze is occurring at a time when (unlike 1907)
few businessmen, economists or Governmental leaders have the foggiest idea
of the overall situation or the vaguest notion of how to deal with it. What
we are seeing is an explosive demand for money from all sectors of the
economy with a "built in" booster of $1 billion a month for the Vietnam war
- all this in the face of world money markets which are literally "panting
for breath."
Note that these were very strong comments since the public was very
enthusiastic about the stock market at that time. In fact, according to
Russell in the same newsletter, mutual fund purchases by the public in
December 1965 were the highest of any December in history. At the same time,
the initial offering by the newly-formed Manhattan Fund (headed by Gerald
Tsai) was nearly five times oversubscribed. 1966 was a very speculative
period, indeed.
The period during late 1974 was a world full of contrasts to that of early
1966. Pessimism was prevalent. The Dow Jones Industrials was selling at a
P/E ratio of 6 and at below book value. Some subscribers canceled their
subscriptions of Dow Theory Letters after Russell's special report on
December 20, 1974 - thinking that Russell had clearly gone out of his mind.
Part of that newsletter is reproduced below:
Now this is how I view it. I think the odds are probably better than 50/ 50
that the Dow and most shares hit a bottom in December 1974. I put this
thesis together with a number of other facts. As you will see in a later
section, the unweighted NYSE average is now down around 77% from the high.
In 1929-32 the unweighted NYSE average went 12% further on the downside - to
an 89% loss. I feel that most shares have now discounted all the forthcoming
bad news, and I am including recession-depression conditions in 1975. We
have been in the third phase of a great primary bear market. We are finally
in the zone of "great values". In many cases, stocks are selling "below
known values". Here's an interesting statistic: The price/ earnings ratio
for the 30-Dow Industrials is now around 6.0 while the yield on the Dow is
6.36. This means that the Dow P/E is below the yield on the Dow. This
happened only once before in the last forty years, and that was during
1948-50.
Second item: The Dow is now selling below its book (or break-up) value. This
has not occurred since 1942. Are these two above Dow "tests" infallible
indications of the final bottom? Not at all, but they do indicate that the
Dow is sure getting down there.
There is no doubt that the 1974 bottom call was one of the greatest stock
market calls in modern history, right up there with Hamilton's 1929, Rhea's
1932, and Schaefer's 1949 calls. Based on the Dow Theory and his own
observations, he told his subscribers the market was a "sell" in August
1987, even though no Dow Theory sell signal has been triggered at the time
(Hamilton and Rhea has always emphasized that one does not usually need to
wait for a Dow Theory buy or sell signal to tell one to buy or sell). That
signal, however, was triggered just days before Black Monday, October 19,
1987, as the Dow Transports confirmed the Dow Industrials on the downside by
breaking through its preceding secondary lows on October 15 (such a signal
in the third phase of a primary bull market is taken to be a primary bear
market signal).
Russell stayed cautiously bullish during the late 1990s. In September 1999,
the Dow Theory generated a primary bear sell signal. Today, Russell still
maintains that we are in a primary bear market, and that the market will not
bottom until stocks have reached the point of "great values" with P/E ratios
below 10 and with dividend yields of greater than 5%. At the age of 79,
Russell is still going strong, publishing a market commentary every Monday
to Saturday.
The Dow Theory Today
The Dow Theory has withstood the test of time - the latest "proof" being
Russell's primary bear market call based on the Dow Theory in September
1999. As with his 1974 primary bull market call, numerous stock market
analysts ignored him, including some of his own subscribers. Various
"trading systems" come and go, but the Dow Theory has been a reliable tool
for the trader/investor for over a century - mainly because the Dow Theory
is not a system, but merely a theory based on the principles as first
developed by Charles Dow, and which is open to interpretation.
Since the 1999 primary bear market signal, a great deal of interest has been
revived in the Dow Theory. However, not a day goes by without spotting
someone who claims an understanding of Dow Theory but who actually only has
a cursory understanding at best. More recently, numerous traders have tried
to reduce the Dow Theory to a "system," where a series of confirmations of
the Dow Jones Industrials by the Dow Jones Transports (or vice-versa) is
taken to be "buy" or "sell" signals without regards to other factors such as
valuation, economic conditions, and investor sentiment.
It is to be said here at none of the above Dow Theorists interpreted the
confirmations of the indexes in that manner. None of them actually waited
for such "signals" to buy or sell - they bought or sold in advance. Waiting
for such "signals," they claimed, would cause them to have missed a
significant part of the move, and such moves can be costly. The primary
purpose of this indicator is to serve as a confirmation of the current
trend, and if one index does not confirm the other (or if it takes a long
time to confirm) then it is a warning sign that the current trend may be
over, and positions may need to be liquidated (or stops may have to be
tightened) or may need to be covered if one is short. Again, the
confirmation of one index by the other is not to be taken as a buy or sell
indicator.
Another variation of this fallacy is that the July and October 2002 bottom
were the true bottoms, and that unless those bottoms were jointly penetrated
by the Dow Jones Industrials and Transports, we are now in a bull market as
interpreted by the Dow Theory since we have made higher highs in both
indexes. Nothing can be further from the truth. Please remember that Dow's
original emphasis was on valuation and economic conditions. All the major
indexes are still overvalued today judging by their P/E and P/D ratios.
Moreover, the higher highs indicator can only be treated seriously in the
third phase of a primary bear market, when pessimism runs extreme and when
stocks are liquidated without regards to values. We had none of that in this
bear market so far.
We believe any serious investor/trader should take the time and try to gain
a true understanding of the Dow Theory. I sincerely believe that the Dow
Theory is even more valuable today than it ever was - in a world full of
hedge funds using price, volume, and volatility breakout systems and with
anyone willing to jump in at the sign of a potential trend. Today's markets
are more emotional than ever and only by knowing the true tenets of the Dow
Theory can one stay firmly planted on the ground with both feet. Ignore the
presses and anyone else who has not taken the time to learn the Theory. Read
all the historical writings by the above Dow Theorists, and I promise you
that this education will be immensely more valuable than any secondary
education you can obtain in a top ten business school or a top five
investment bank today. Our site will try to incorporate the Dow Theory in
our analysis, but please bear with us from time to time since we are still
students of the Dow Theory ourselves.
Henry To, CFA is the managing member of Independence Partners, LP, a SEC
registered hedge fund.
He is also editor of the investment website, www.marketthoughts.com.
Article Source: http://EzineArticles.com/
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