The Dow Theory has come under attack from perma-bulls who have little respect for any stock index that isn’t the S&P 500. In this article we want to cover this technical tool (make no mistake it is a relevant and terrific technical analysis tool).

The theory was founded around the turn of the twentieth century by Charles H. Dow, then editor of the Wall Street Journal. As part of his studies, he “invented” the concept of tracking segments of the stock market separately as “averages” or indices. The theory was initially documented by him in a series of editorials published by the financial paper he ran. His view of the theory at the time was more as a barometer of business conditions which he believed would be helpful for investors. After Dow’s death in 1902, his successor as editor for the Wall Street Journal, William Peter Hamilton, took the theory to a new level of application, defining the science of the theory and applying it as a forecasting tool with considerable success from 1902 to his death in December 1929, only six weeks after arguably the worst stock market crash of all time, surely so in its repercussions.

The original indices were set up by Charles Dow in 1896 (which is why the data only goes back that far). He set up two averages. One was the rail averages (which has since migrated to the Transports) and consisted of 20 stocks. Today the Trannies still have 20 stocks. The second average he set up was the Industrials average which at the time consisted of only 12 stocks. It was increased to 16 stocks in 1916, and 30 on October 1st, 1928 — the number of Industrial stocks in the average today. The specific stocks change from time to time due to their market capitalization and to fully represent the major market segments. General Electric is the only stock that has been in the Industrials from day one through now. In 1929, the Utility stocks were pulled out of the Industrials and a separate Dow Utilities index was established which now consists of 15 stocks.

Dow Theory only concerns itself with the Transports and the Industrials. It assumes that the averages discount everything known to man. Dow Theory sees market movements occurring at three different waves of time frames all at the same time. The Primary Trend is the broad long-term up or down movements in prices, lasting a year or more. Inside the Primary Trend is the Secondary Trend which can either interrupt the Primary Trend’s progress or push it forward, depending upon whether this intermediate-term price trend is going with the grain or against it, lasting typically from a few weeks to several months or occasionally more than a year. Then there are the Minor Trends, short-term, lasting anywhere from a few days to a few weeks. Again, the Minor trend can move prices either in the same or opposite direction as the Primary or Secondary trend.

The predictive value of the Dow Theory aims at defining Bull and Bear markets. There are several tools to size up the present investing environment and forecast the future. First is values. Dow Theory believes market valuations swing from too high to too low like a pendulum, and that until Price/Earnings ratios get to overvalued extremes, something along the lines of PEs over 20, the Primary Bull trend may not be over. Conversely, Bear markets do not typically end until PE ratios become undervalued, something along the lines of under 10. Valuations are also measured by looking at the Dividend Ratios of a stock versus its long-term historical mean. Typically, Primary Bull markets are not likely to be complete until dividend ratios drop below 2 percent or so. Bear markets are not likely over until dividend-to-stock-price ratios are over 6 percent or so. These measures are not hard and fast, which is where the art meets the science. But these are general guidelines that have worked for over a century.

At true bear market lows we also find that the Dividend Yield tends to be roughly equal to the Price/Earnings ratio. For the benefit of any who may question the Industrials we will use the S&P 500 for this example. According to Dow theory, the first great bear market low occurred in 1932. At that low, the Yield on the S&P was 10.50 with a Price/Earnings ratio of 10. In 1942, the Yield was 8.71 with a Price/Earnings ratio of 7.3. The 1974 low marked the low for the second great bear market and history shows that at that low the Yield on the S&P 500 was 5.9 with a Price/Earnings ratio of 7.24. In October 2002 the Yield on the S&P 500 was 1.90 with a Price/Earnings ratio still at an historical sky high level of 29.95. With the Dividend Yield and Price/Earnings ratio hardly at parity, as the 2002 low formed, this was not a long term bottom from which full blown secular bull markets emerge.

The other key tool that gives the Dow Theory its predictive value is the principle of Confirmation and Non-confirmation. This principle says that the two averages, the Transports and the Industrials must confirm each other.

Here’s how this works and why. The thinking is that in the economy, goods produced must be shipped. To gauge an accurate read on the economy, production should move hand in hand with shipping. If industrial production is rising, then it stands to reason shipping should be on the rise as well. If industrial production is rising, but shipping is slowing, then it signals something is wrong with the normal flow of the markets. Perhaps excess product has been manufactured, but sales (as measured by shipping) are lagging. If goods are being shipped at a rising clip, but production is falling off, it signals something is wrong with the economy, that perhaps shipping is soon going to follow production lower since there won’t be as much product to ship. If the decision-makers who produce goods based upon orders, or expected orders, are Bearish, it will be reflected in a declining Dow Industrials index. So, for a healthy economy, both the Industrials and the Transports should rise in sync.

Applying the philosophy to the averages, a change in the Primary trend of stocks must and only occurs when the two averages confirm each other. If the Primary trend in stocks was down, a change in trend to the upside is only valid if both the Industrials and the Transports rally to new highs. Should one index rally to new highs, but the other fail to do so, then the new rising trend is suspicious, and should not be trusted with your investment capital. The same applies in reverse. If stocks are in a confirmed Primary rising trend, and then one index declines to a lower low, but the other fails to do so, marking only a higher low than before, then the move down becomes suspicious, is not to be trusted, and it is assumed that the Primary rising trend remains in force. Non-confirmations also apply to Secondary stock movements.

Frequently non-confirmations occur during a Primary or Secondary trend in the same direction as the trend. For example, in a rising trend the Transports may make a higher high, but the Industrials fail to do so. That non-confirmation does not signal a trend change. It only gives pause for concern. The rising trend is assumed to remain in force since it is not necessary for confirmations of an ongoing trend to occur on the same day. Confirmations may lag, but still keep the trend in place. It can be said, however, that the longer it takes for one index to confirm the other in an ongoing trend, the more suspicious that trend becomes. It could signal that the trend is running out of gas. You like to see the two indices confirm soon to add confidence to the ongoing trend. Still, until such time as a confirmed reversal has taken place, the assumption is that the ongoing trend remains in force.

Here are a few quotes from the great Dow theorists of the past on this subject.

Dow Theory only considers closing prices for each day. Our only comment here is that this has stood the test of time.

All of which brings us to now. The last Primary trend reversal occurred in 1999, and it was a sell signal. This has not been reversed, therefore the rally from October 2002 through February 2006 has been a Secondary rising trend inside a Primary declining trend, according to Dow Theory. That Primary trend sell signal occurred because after both the DJIA and Trannies hit confirmed all-time highs on May 12, 1999 and May 13, 1999, the Trannies failed to confirm the DJIA’s higher high in August 1999. That higher high non-confirmation was then followed by confirmed lower lows in both indices in September 1999 — a Primary Sell Signal. This sell signal was confirmed in 2000 when the DJIA went on to reach a higher all-time high January 14th, 2000 that the Trannies failed to confirm. That non-confirmed top was then followed by confirmed lower lows in February 2000. Thus the Primary Sell signal was confirmed. The averages have not been able to give a Primary Buy signal since.

Recently the Trannies — after six years — hit a new all-time high. But the DJIA has failed to confirm, establishing a major Primary trend non-confirmation that dates back for six years. That is a very long time for a non-confirmation. Back on January 14th, 2000 the Industrials hit an all-time high of 11,722.98. The Transports hit their all-time high almost six years later on February 15th, 2006 at 4,442.28. This is far too long for a confirmation to the upside, and instead is a major league non-confirmation requiring the Dow Industrials to confirm the Trannies new all-time high with a new all- time high of their own. The Industrials must now top 11,722.98 for a Primary Buy signal. That is no guarantee as they now sit approximately 600 points (5.10 percent) below that task with markets topping.

Non-confirmations are essentially saying something is seriously wrong with the economy and markets, so be careful. The way Edwards and Magee put it in their outstanding technical analysis tome is, “The fact is that, in Dow Theory, the refusal of one Average to confirm the other can never produce a positive signal of any sort. It has only negative connotations,” (Technical Analysis of Stock Trends, eighth edition, edited by W.H.C. Bassetti, St. Lucie Press, 2001).

Now for a look at Dow Theory bull and bear market periods. When studying about the bull and bear markets of the late 1800s and very early 1900s, Tim Wood realized that the bull and bear markets the early Dow theorists wrote about were much shorter in duration. It became obvious that as our country grew, more and more people entered the markets. As a result, the bull and bear market periods, as defined by Dow Theory, evolved and also grew in duration. The first such great bull market was born out of the 1921 bear market low. From that low the first extended or great bull market advance began. This advance lasted 8 years and carried the market up into the infamous 1929 top. This first great bull market period carried the DJIA up in that “Primary” advance, a total of 568%.

The next great bull market began in 1942 and topped in 1966. This time the “Primary” bull market was extended even further in time lasting some 24 years. As a result, the magnitude of the advance also grew. This time around, the second great bull market pulled the Industrials up 1,076%.

The last and Greatest Bull market of all time began with the 1974 Phase III and bear market low. This time, the “Primary” bull market advanced an unprecedented 26 years topping in January 2000. This mammoth advance carried the Industrials up some 2,061%.

Besides the growth aspect of these great bull market periods, there is another important point. Note that the first advance was 568% with the second one being 1,076%. The point here is that the second advance doubled the magnitude of the first. But, also note that with the last great bull market period being 2,061%, its magnitude was double that of the second great bull market. Yes, each of these great bull market periods have grown in duration and doubled the magnitude of the previous advance.

But, when reading about the bull and bear market periods of the past, another relationship became obvious. That being, the duration of the bear market in relationship to the preceding bull market. In researching this, Tim quickly realized that the bear market periods, as defined by these great Dow theorists, were roughly one-third the duration of the preceding bull market. But what about the Great bull and bear market periods?

Let’s take a look. The 1921 to 1929 bull market was 8 years in duration with the bear market that followed running 3 years from 1929 to 1932. Therefore, the bear market duration was 37.5% of the preceding bull market. The 1942 to 1966 bull market was a 24 year affair with the 1966 to 1974 bear market running 8 years in duration. So, this bear market lasted 33.3% of the duration of preceding bull market. As stated above, the last great bull market ran from the 1974 low into the 2000 top for a duration of approximately 26 years. So, 33.3% of the previous 26 year Bull market would mean that this bear market would last some 8 ½ years. 37.5% of the duration of this last great bull market would mean that it would last approximately 10 years. So, in spite of the fact that the bull market periods have grown in duration, the bull/bear market relationships have held constant. Therefore, from a historical perspective of true Dow Theory bull and bear market relationships, the 2002 low was NOT the bear market low.

Another very very important and often over looked aspect of the Dow Theory that very few understand is the phasing of bull and bear markets. The great Dow theorist E. George Schaefer stated: “There are three principle phases of a bear market: the first represents the abandonment of the hopes upon which stocks were purchased at inflated prices; the second reflects selling due to decreased business and earnings, and the third is caused by distressed selling of sound securities, regardless of their value, by those who must find a cash market for at least a portion of their assets.” These words are merely a guideline and here too the application of this concept is where the art and the science meet.

The great Dow theorist of the 1930s, Robert Rhea, described the three phases of the bear market in a very similar way. More importantly, Rhea goes on and states: Each of these phases seems to be divided by a secondary reaction which is often erroneously assumed to be the beginning of a bull market.” Does this sound familiar or what? Rhea also states: “ Such secondary movements seldom prove perplexing to those who understand the Dow theory.”

Tim has spoken many times in the past about Dow Theory phasing. Today he wants to address this topic again and perhaps an example would be helpful to illustrate this concept. Since the Dow Theory currently tells us that we are still operating within a Primary bear market, Tim will use the more recent 1966 to 1974 bear market to illustrate this point. He specifically wants to compare the three phases of the 1966 to 1974 great bear market to what appears to be occurring today.

Phase I of the second great bear market began at the previous bull market Phase III top in February 1966. This top was confirmed under Dow Theory in May 1966. From this top the market declined into the Phase I low in October 1966. This Phase I decline is marked in blue on the chart above and it carried the Industrials down some 25%. From this Phase I low the typical rally that serves to separate Phase I from Phase II began. This rally carried the market up some 32% from its lows over a 26 month period and is marked in green on the chart above. During this 26 month advance you can see that there were a couple of false breakdowns that the market was able to recover from and inevitably push higher.

Be assured that the Dow theorists of that day understood that this advance was the rally separating Phase I from Phase II. Tim also suspects that this rally lasted longer than they expected and again, Tim attributes that to the fact that these bull and bear market periods continue to grow in duration. However, those who truly understood the Dow Theory are on record for knowing what was going on and the longer the market held up the more bullish the general public became in spite of these warnings. After the recovery from the second false break Tim is sure that the public was convinced that a new bull market was underway. They probably proclaimed that anyone stating anything other than this “obvious” bull market that was underway had to be in error and that the Dow Theory had finally been proven wrong.

However, in spite of the false breaks, the bullish sentiment, false recoveries and claims of new bull markets, the Dow Theory prevailed and the decline into the Phase II low carried the market down some 36% over a 17 month period. This Phase II decline is marked in yellow on the chart above.

Then came the rally separating Phase II from Phase III of this ongoing secular bear market. This rally carried the market up 66% over a 32 month period. This advance is also marked in green on the chart above. Once again, the world was convinced that the bear market was over. After all, the market had made a new high. How in the world could we still be in a bear market with the market at new highs? Those crazy Dow theorists had to be wrong this time around.

But, once again, the Dow Theory phasing prevailed and the Phase III decline took the market down 45% into the final low of the second great bear market. This time, those who understood the Dow Theory began looking for the bottom. In fact, Richard Russell actually issued a special report in December 1974 stating that conditions were right for the bear market bottom. In this special report he actually talked about the phasing and value as part of his reasoning.

This brings us to our current chart below. From the 2000 top, the market dropped some 38% over a 33 month period into the bear market Phase I low in October 2002. This decline is marked in blue on the chart below. From that low the typical rally separating Phase I from Phase II began. Yes, there have been several false breaks in which it appeared that the decline into Phase II was underway. But, just as with the 1966 to 1968 rally, this rally has drug on and much of that is obviously because of the great re-inflation efforts of the FED. Just as with the 1966 to 1968 rally, the bullish sentiment is off the chart. Just as with the 1966 to 1968 rally the public is convinced that a new bull market is underway. Just as with the 1966 to 1968 rally the Dow Theory is being proclaimed as wrong.

Tim Wood has read every known writing of Charles H. Dow, William Peter Hamilton, Robert Rhea and E. George Schaefer. From a Dow Theory perspective there is little doubt about the interpretation of the rally out of the 2002 low. Stocks did not represent great values at that low, the historical duration for typical bull/bear market relationships were not met, and according to Dow Theory, it was only the Phase I low. All indications are that what we have seen is an extended “Secondary Reaction” or counter trend rally separating Phase I from Phase II. The problem is that this rally has been so great in duration that it has even most seasoned market analysts thinking we are in a bull market. The problem is that very few people truly have an in depth understanding of the Dow Theory and without this understanding it is utterly impossible to comprehend just how large and perverse the ongoing setup actually is. You have been warned!

The next chart shows divergences between the Dow Industrials and the Dow Transportation Averages over the past seven years. What is fascinating is that every single time there was a non-confirmation of one average by the other, a stock market crash or meaningful sell-off followed shortly thereafter. Every time! Therefore, just as the great Dow theorist’s of the past warned, when the averages dissagree they are indeed shouting “be careful. ” At the present, the Primary non-confirmation still stands, while the Secondary hurdle has been cleared. [See Dow Theory Clears the Secondary Hurdle]

The second chart shows the six-year primary upside non-confirmation between the Industrials and the Trannies. This is telling us the recent new highs and Bullish fervor from the Trannies is not to be trusted. We show when the Primary Dow Theory Sell Signal emerged which has since not been reversed. We also show the confirmation of this Primary Sell signal.

Why should Dow Theory be trusted? Does it work? Edwards and Magee in the above noted book point out brilliantly that had you invested in the Dow Industrials in 1897, and bought and sold based upon Dow Theory buy and sell signals for 103 years, by the year 2000 you (or your deserving heirs) would have had nearly ten times the money than had you stuck the money in the Dow Industrials and held it 103 years, with no intervening buy and sell transactions. We recommend you buy this book. The first five chapters deal with Dow Theory.

As stated above, Richard Russell used the Dow Theory to call the 1974 bear market low, but he also used the Dow Theory to call the 2000 top. Tim Wood used his unique combination of Dow Theory and cycles to call the 2000 top. William Peter Hamilton called “A Turn in the Tide” using Dow theory in 1929. This call is documented at www.cyclesman.com/calling_the_turn.htm After Hamilton’s death in 1929, Robert Rhea used the Dow Theory to call the 1932 bottom within days of the low. This can be read at www.cyclesman.com/rhea_1932.htm Unlike any other stock market discipline, the Dow Theory has stood the test of time and that in and of itself is a reason enough for us to trust the Dow theory. For a more complete history of the Dow Theory you can also visit www.cyclesman.com/History_of_Dow_Theory.htm

Copyright © 2006 Tim W. Wood, CPA & Robert McHugh, Ph.D.
All Rights Reserved.

The statements, opinions and analyses presented in this newsletter are provided as a general information and education service only. Opinions, estimates, buy/sell signals, and probabilities expressed herein constitute the judgment of the authors as of the date indicated and are subject to change without notice. Nothing contained in this newsletter is intended to be, nor shall it be construed as, investment advice, nor is it to be relied upon in making any investment or other decision. Prior to making any investment decision, you are advised to consult with your broker, investment advisor or other appropriate tax or financial professional to determine the suitability of any investment. Neither Tim Wood, nor Main Line Investors, Inc. nor Robert D. McHugh, Jr., Ph.D. shall be responsible or have any liability for investment decisions based upon, or the results obtained from, the information provided. Copyright 2006, Main Line Investors, Inc. All Rights Reserved.

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