To be honest, our framing of Dow theory goes a bit off script from the traditional view. I think that the better buy signals for Dow theory actually happen in the confirmation of major and minor market bottoms (like the one I called last November). Confirmation of new highs thus become chances to start looking at when to exit positions, rather than times to get over-bullish. Using other technical indicators will help in figuring out when a market top is imminent. For example, if the market becomes oversold after a new Dow theory buy signal, chances are a market top is being formed. Thus, I view the current market as putting in a top and will not be buying yet. At the same time, I won't be shorting the market yet since divergence isn't showing up.
Richard Russell - godfather of financial newsletters, author, Dow Theory expert and longtime bear - just turned bullish.
One reason for his conversion: the Dow Theory, which is said to have formed the basis for all modern technical analysis through its definition of a trend and its reliance on studying price action.
The Dow Theory says the market is in a bullish trend if one of its averages - either the Dow Jones Industrial Average or the Dow Jones Transportation Average - advances above a previous important high and is followed by a similar advance in the other average.
The Transportation Average broke through its record high in January, and the Industrial Average hit an all-time high on March 5.
"With the Industrials and the Transports both in record high territory, I think being in the market is justified under Dow Theory," Russell wrote in his March 11 Dow Theory Letters, the oldest investing newsletter continuously written by one person.
But that's not to say it'll be a smooth ride for investors.
"My intuition tells me that there will be an early period [around now] of erratic and uneven scary advance, this to occur while formerly battered investors work up the nerve to enter this market," Russell predicted.
"Then the action will smooth out as the crowd gathers courage and confidence.Finally, in the last stage of this advance we might see the stock averages rise in parabolic fashion.This will be the time to pack our bags and get out."
Origins of the Dow Theory
The more than 100-year-old Dow Theory originated from over 250 editorials in The Wall Street Journal written by Charles Dow, founder and first editor of the Journal and co-founder of the Dow Jones and Co.
The premise behind the Dow Theory is that the economy should be prospering when both the companies making products, measured by the Dow Industrials, and the companies delivering them, measured by the Transports, are thriving.
The Dow Theory has genuine value in predicting the market, some studies suggest.
One was conducted in the mid-1990s by three finance professors: Stephen J. Brown of New York University, William Goetzmann of Yale University, and Alok Kumar of the University of Miami.
One was conducted in the mid-1990s by three finance professors: Stephen J. Brown of New York University, William Goetzmann of Yale University, and Alok Kumar of the University of Miami.
Their results showed that from 1930-1997, the Dow Theory beat a buy-and-hold strategy by an annual average of 4.4% per year.
And in November 2011, Jack Schannep, editor of TheDowTheory.com online newsletter, showed that using the Dow Theory gave a total annualized return from 1953-2011 of about 1.5% more than buy-and-hold per year.
Russell says not only the Dow Theory, which he analyzed in his book "The Dow Theory Today," but also the Federal Reserve's easy-money policies give him reason to be optimistic about the markets.
"By taking a position in the market, you'll be casting yourself on the side of the optimists, and you'll also be casting your vote on the side of Ben Bernanke and the Feds," Russell said in his March 11 newsletter.
"This market lives or dies by the edicts of the Fed.If Ben Bernanke's Fed has any intention of taking its heavy foot off the gas, my guess is that the Fed will provide the markets with ample early hints and warnings.So what is there to do?"
Russell's answer: Play the Dow Jones Industrial Average and buy the SPDR Dow Jones Industrial Average ETF (NYSE: DIA), also known as the Dow diamond.
Caveats of Dow Theory Today
But Money Morning Chief Investment Strategist Keith Fitz-Gerald warned the Dow Theory doesn't always deliver.
Before the latest stock market rally, the last time both the Dow Transports and overall Industrial Average reached record highs was in July 2007. Less than three months later, the Dow peaked and began its long slide from over 14,000 to 6,626.
"When the cycles work, they're great; but when there is a mismatch, it's investors beware," Fitz-Gerald said.
And because the theory must wait for the second index to confirm the movement of the first one, there is a faulty time delay built into the model.
"That means Dow Theory can lag the markets significantly, missing not only the huge gains that led to the signal being confirmed, but reversals too," Fitz-Gerald commented.
Furthermore, Fitz-Gerald said, the theory that the economy can be measured by the movement of these two averages is outdated.
"Transportation and industrials are no longer the core economic drivers that they once were, so I question their relevance when technology and banking, for example, are not included," Fitz-Gerald said. "In other words, the economy is far more segmented than it was when the theory was created. The real key in today's markets is buy and manage."
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