HOW NOW, DOW THEORY?
By Mark Hulbert 10:36 PM ET Mar 15, 2007 ANNANDALE, Va. (MarketWatch) -- What does the Dow Theory have to say about the stock market's recent weakness? You might wonder why we would even bother to check. It was just over a month ago that the Theory flashed a bull-market reconfirmation signal, after all. (Read Feb. 2 column) The Dow Jones Industrial Average closed Thursday nearly 500 points lower than where it stood then. Some bull market, you might say. The reason to nevertheless pay attention to the Dow Theory: Its long-term record is quite good. According to a study that appeared in the August 1998 issue of the prestigious Journal of Finance, conducted by Stephen J. Brown of New York University, William Goetzmann of Yale University, and Alok Kumar of the University of Texas at Austin, a portfolio that switched between stocks and cash according to their interpretation of the Dow Theory beat a buy-and-hold by an annual average of 4.4 percentage points per year between 1930 and 1997. The Dow Theory was the brainchild of William Peter Hamilton, who was editor of the Wall Street Journal for several decades in the early part of the last century. He introduced his market timing ideas in dribs and drabs in editorials he wrote for the Journal over a nearly 30-year period, and never translated those editorials into a series of precise and unambiguous rules. Because of these dubious origins, followers of the Dow Theory endlessly debate the finer points of what it might say about this or that market condition. But, at least in general terms, most followers would agree that a Dow Theory sell signal is not triggered until three events occur in succession: -- The stock market must undergo a significant correction, with "significant" defined in terms of length (more than just a couple of days) and percentage decline (more than just a few percentage points). -- In the market's rally attempt following this correction, either the Dow industrials or the Dow Jones Transportation Average , or both, must fail to rise above where they stood prior to the beginning of the correction in step 1. -- In the market's subsequent decline following this rally attempt in step 2, both the DJIA and the DJTA must drop below the lows they set in the correction in step 1. Given these conditions, it seems clear that the stock market's recent weakness comes nowhere close to producing a Dow Theory sell signal. Indeed, depending on which Dow Theorist is doing the interpreting, it is not clear that we have even made it beyond the first of the three steps. The reason I say this: The correction that occurred from the Dow industrials' all-time high on Feb. 20 to its low on March 5 lasted just nine trading sessions, and less than two weeks of the calendar. Its magnitude was just 5.8%. There are some this length and magnitude of a correction does not qualify as being significant enough. But even if you do think it does, that still would mean we're currently only in step 2 of the three-step process that would eventually produce a sell signal. As of Thursday's close, the Dow industrials had regained 109 of the 736 points it had lost between Feb. 20 and March 5. Regardless of whether you think we're still in step 1, or have advanced to step 2, however, the message of the Dow Theory would appear to be the same: A sell signal has not been issued. And on one thing William Peter Hamilton was clear: We should presume that the previous signal remains in force until it is reversed. And that means, to the extent you follow the Dow Theory, you will act as though the bull market remains alive and well. This attitude of giving the bull market the benefit of the doubt helps explain a comment earlier this week from a prominent Dow Theorist. Richard Moroney, editor of Dow Theory Forecasts, wrote earlier this week to clients that "With near-term volatility likely, a move to 11,400 on the Dow Industrials would not be surprising. Market action has been consistent with a correction in an ongoing bull market, and the Dow Theory remains in the bullish camp." Lest you think there are no flies in the ointment, however, I should note that not all Dow Theorists are currently bullish. While two of the three Dow Theory services I follow are -- Moroney's as well as Jack Schannep's TheDowTheory.com -- the third, Richard Russell's Dow Theory Letters, is bearish. This is for a variety of reasons, one of which is that, on his reading, the Dow Theory above else is about values, and stocks are much closer to being overvalued than undervalued. -----------------------------------------------------------------------
