Rational Advisor

From our Toronto Due Diligence, something that the Large Cap manager had said piqued my interest. He had commented on the Dow Theory and how worrisome it was getting. He also said that he paid a lot of attention to it over the alst 50 years, although not perfect as a tool, it was more than often correct.

“The Dow Theory has put us in the bearish camp for the first time since 2003,” says Bill Tynkaluk of Leon Frazer at the conference. “It’s a very clear signal.”

He gave me a quick explanation of the theory, the rationale behind it and what it’s telling us:

The Dow Theory is named after Charles Dow; he is the Dow in the Dow Jones industrial average and the founder of the Wall Street Journal.

The theory one central point that can be summed up by a simple rule: When the trains slow, the economy does too.

Chucky 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 him, manufacturer’s profits rise because they are producing more products and therefore, will increase the demand for transportation and thus send the transportation 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. Makes sense so far.

When he died in 1902, his student Mr. William 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.

I know, we live in a new funky tech world, and railways don’t mean squat, this info-age economy is just too complex to be boiled down into a simple goods-on-rails thesis. However that said, the theory famously did predict the internet fueled tech wreck in January 2000, but it did it a year before the crash!

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 shows that both industrials and transports are at lows together in tandem. 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 followers 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 talk about the length of the pullback or how severe the bear market will be.

What are some of the things that have survived the bear markets of the Dow theory – strangely Bonds and Dividends! Those that were doing the most miserable the year before!

Just a thought!

Rational - Dogs are the leaders of the planet. If you see two life forms, one of them’s making a poop, the other one’s carrying it for him, who would you assume is in charge.

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