Dow Theory Says SELL

Dow Theory Says SELL

By Mark Hulbert, MarketWatch | 22 November 2007

ANNANDALE, Va. (MarketWatch)—

With the Dow Jones Industrial Average's finish on Wednesday below its August lows, the three Dow Theory newsletters I track are solidly in the bearish camp. The Dow Theory, for those not familiar with it, traces to a series of editorials that appeared over the first three decades of the last century in The Wall Street Journal. Those editorials were written by William Peter Hamilton, then the editor of that newspaper, on the basis of conversations he had with Charles Dow, the founder of Dow Jones & Co., the newspaper's publisher. (Dow Jones is the owner of MarketWatch, the publisher of this column.) Hamilton's editorials leave lots of room for followers to argue over the more esoteric points of the theory.

But the general outlines are clear enough of what is required to trigger a Dow Theory sell signal:

1. Both the Dow Jones Industrials Average ($INDU) and the Dow Jones Transportation Average ($TRAN) must undergo a significant correction from joint new highs.


2. In their subsequent rally attempt following that correction, either one or both of the averages fail to rise above their precorrection highs.


3. Both averages must then drop below their respective correction lows.

Step No. 1 began this past July, by the correction that began from that month's highs. Step No. 2 was satisfied during the rally that began from the market's mid-August lows, in which the Dow Jones Transportation Average failed to surpass its precorrection high.

With the DJIA's close on Wednesday below its August lows, Step No. 3 is now satisfied too, since the DJTA earlier this month had already closed below its August lows.

Why should you care about the Dow Theory?

One reason is that many investors pay close attention to it. I suspect that was one of the reasons that the DJIA seesawed all day Wednesday above and below its August closing low of 12,846. In fact, it wasn't until the final few minutes of trading that it became clear that it would close below that level, and thereby trigger a Dow Theory sell signal.

The Dow Theory's popularity should trigger additional selling when investors currently on vacation return from their Thanksgiving holidays, either on Friday, or more likely this coming Monday.

Another reason to pay attention to the Dow Theory: Its long-term track record is good. Confirmation comes from none other than the Ivory Tower, which traditionally has pooh-poohed the notion that the stock market could be timed.

Consider a study 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 Texas at Austin. They fed Hamilton's market-timing editorials from the early decades of the last century into neural networks, a type of artificial intelligence software that can be "trained" to detect patterns.

Upon testing this now "trained" neural network version of the Dow Theory over the nearly 70-year period from 1930 to the end of 1997, they found that it beat a buy-and-hold by an annual average of 4.4 percentage points per year [[That's a HUGE amount! Over 40 years, it would have outperformed buy-and-hold by 560%.: normxxx]]. Their study appeared in the August 1998 Journal of Finance

Normxxx    
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