Dow Theory Issues A Bearish Warning

By Jason Chow
Globe Investor Magazine, Nov. 30, 2007

The recent spiral in the markets has caused another round of debate over whether or not the bull run of the past several years has finally come to an end. Will this week's rally last or will it prove to be short-lived?

Well, for devotees of a century-old doctrine called the Dow Theory, the answer is in: The bears have finally arrived.

"The Dow Theory has put us in the bearish camp for the first time since 2003," says Richard Moroney, editor of Dow Theory Forecasts in Chicago. "It's a very clear signal."

How can the disciples of one of the oldest market-timing methods be so sure? A quick explanation of the theory, the rationale behind it and what it's telling us:

Origins
The Dow Theory is named after Charles Dow, founder of the venerable Dow Jones industrial average and the Wall Street Journal. A studious market follower, he wrote 255 editorials about the market, and after his death in 1902, his protégé William Hamilton would compile the wisdom and codify it. Dow was a strong believer that studying the price action of stocks could have predictive powers and is long credited as a pioneer in technical analysis of financial markets.

How it works
The theory, as a whole, is a comprehensive view of the market with several tenets, but the one central point that most market gurus always highlight can be summed up by a simple rule: When the trains slow, the economy does too.

Mr. Dow initially created two indexes: One to follow the industrial companies that made goods and another to represent the rail companies (now called the transport index) that shipped the goods. According to Mr. Dow, manufacturer's profits rise because they are producing more products and therefore, will increase the demand for transportation and thus send the latter sector's profits rising as well. The two indexes are inextricably linked, Mr. Dow wrote, and if an investor wants to judge the health of manufacturers, they're better off watching how the rail stocks are doing because they're the ones that are actually carrying the industrial group's output.

Mr. Hamilton took Dow's logic a step further and made it into a technical rule for the markets: Whenever the two indexes achieve new highs together, a correction will eventually follow. When they do fall, the indexes will attempt to rally back to their highs. If this subsequent rally fails to crack the pre-correction high, then both indexes will fall to new lows.

Critics of the theory point out that our information-age economy is far more complex to be boiled down into a simple goods-on-rails thesis. The theory famously called an end to the Internet-fueled bull market in January 2000, but over a year before the markets' peak.

However, a major study of the theory nine years ago by finance academics at New York University and Yale University concluded that the theory is an effective, if conservative, measure: You won't get maximum returns by getting out at the top, but you also won't be left hanging onto stocks through bad reversals.

What does the Dow Theory tell us now?
The Dow Theory attracted attention in October when the transport and industrial indexes first went different ways. As the industrials were rising in October - what now looks like a dead-cat bounce after the late-summer collapse of the U.S. markets - the transport index refused to step up in tandem. By mid-month, the industrials went south and the transport index sank further down, with both establishing lows under their previous August dips, two weeks ago. Hence, the bear signal.

"We were fairly encouraged in October," admits Mr. Moroney. "The transports were going in the right direction. We were ready to give it the benefit of the doubt, but by November, the transports went down and everything started to deteriorate." He adds, "The theory works because it gives long-term signals. You need confirmation from both averages. It requires significant things to happen before a change in the trend. The two indexes are two different barometers and the two together reduce the chances of a false signal."

The outlook
History shows that the future doesn't look good. The last time the Dow Theory flashed a bear flag, it remained bearish for over three years from January 2000 to May 2003. The Dow devotees missed out on the gains through 2000 but they also avoided the massive bear market of the following two years.

How long might this downturn last? The theory does not prognosticate the length of the pullback or how severe the bear market will be. Mr. Moroney wouldn't give any forecasts either, though he did think that there's much more on the downside to come.

"It is giving a bear market signal, and a bear market signal is about a 20-per-cent decline off the high, and based on that rule of thumb, we're only halfway there."

Special to The Globe and Mail