Does Dow Theory work?

Many market-watching systems claim to provide a foolproof "signal" as to where the stockmarket is going next. One of the oldest is Dow Theory, which evolved from the writings of Charles Dow the founding editor of The Wall Street Journal and William Peter Hamilton, his successor. At heart, Dow Theory is a trend-following system. You buy when the market is in a rising trend, and sell when it is falling.

The system monitors two indices: the Dow Jones Industrial Average (an index of some of the biggest stocks in the US) and the Dow Jones Transportation Average (an index of transport-related stocks). For either a "buy" or a "sell" signal to be generated, both transport stocks and the wider market have to be moving in the same direction. When the two diverge, it may forewarn of a change in trend (there are many other nuances, but this lies at the core of the strategy).

The rationale behind the theory is that a genuine economic boom will drive up demand for transport services, as firms ship in raw materials to their factories, then ship out finished goods. Similarly,in a recession, firms will cut shipments of both raw and finished products. If a boom is "for real", then gains for industrial companies should be mirrored by rising transport stocks. If transport shares don't "confirm" the wider market move, then it may be unsustainable, or the trend may be about to change.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

Dow Theory suffered a setback in 1934 when economist Alfred Cowles published a study suggesting that a simple "buy and hold" strategy would have beaten a Dow practitioner. Modern critics also note that today's market is dominated by service sector firms such as banks which don't transport large quantities of goods, rendering the transport index less useful.

Yet it remains very popular helped by a 1998 analysis by Stephen J Brown of New York University and Yale's William N Goetzmann and Alok Kumar, which found that Cowles' paper had missed the fact that, if you adjusted for risk, Dow Theory beat "buy and hold" (in other words, it made higher returns relative to the risk involved). They also found that a Dow strategy beat the market between 1930 and 1997.

However, there are several catches. The main one is that the theory is vague as to what exactly constitutes a trend leading Dow theorists to frequently disagree over interpretation. That's a problem, because precision also seems to matter with market timing the 1998 study found that those who waited until the day after a trading signal was generated failed to beat the wider market. In all, we'd stick to using fundamental-based valuation measures for long-term investing.