Has Dow Theory had its day?

Get out of the American stockmarket. That's what many followers of Dow Theory, one of the oldest surviving market timing systems, believe you should do right now. Are they right?

What is Dow Theory?

In the late 19th century, Wall Street Journal founder Charles Dow wrote a series of editorials laying the foundations of Dow Theory. The system is designed to tell you when the primary' market trend turns from being bullish (rising) to bearish (falling), or vice versa. You buy the market when this primary trend turns bullish and you sell when it turns bearish.

How do you tell when the trend has changed? There can be temporary reversals stocks can drop for a time during a bull market, for example. But one key way to spot a definitive shift in trend is that a movement in industrial stocks (as measured by the Dow Jones Industrial Average) must be reflected by changes in transport stocks (measured by the Dow Jones Transportation Average index). Why?

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When an economy picks up, firms order more stock. That means more business for freight firms that ship the goods around. So transport stocks should start doing well if there's a genuine upturn. Similarly, when the economy turns down, you'd expect transport stocks to fall.

So when both indices are clearly heading higher, you're in a bull market. When they're dropping, it's bearish. And if the two diverge if the industrials head higher, but the transport stocks don't confirm' the move, for example you should be looking out for a potential trend change.

That's exactly what's happening now, say some theorists. Transport stocks have been weak this year, even as the more closely watched industrials have gained.

Does it work?

Like any system, Dow Theory has its fans and its detractors, but its longevity suggests there's something to it. One study by New York and Yale University researchers published in the Journal of Finance, for example, claimed that a Dow Theory-based system beat a buy-and-hold strategy by 2% a year between 1929 and 1998. It also issued a sell' signal in November 2007, pretty good timing ahead of the great financial crisis in 2008.

But lately, it doesn't seem too hot. As Joshua Brown notes on The Reformed Broker blog, "the trannies and industrials have been utterly divorced from one another for the entire second half of the year". Yet we haven't seen any sort of crash.

One problem is that while the basics of Dow Theory are fairly straightforward, the details are open to interpretation. As Mark Hulbert noted last month on Marketwatch.com, two of the three Dow theorists he watches have issued a sell signal, but one still thinks the primary trend is bullish.

More fundamentally, some critics argue that transport stocks have become less critical as indicators in the age of the internet. Modern economies are less dependent on old-fashioned manufacturing and stock distribution processes than they once were, which makes the signal unreliable.

Don't dismiss it just yet

We're not so sure. Dow Theory may be down, but it's not out. High-tech firms such as Apple still need to ship components around the world. Amazon.com has yet to master sending "plasma TVs via cable modem", as analyst Paul Shread puts it on Internetnews.com.

And as Neil Irwin notes in the Washington Post, American manufacturing is in good health rather than terminal decline, contributing 20% of the growth in global economic output in the decade to 2010. It may use fewer staff, but it still makes and transports huge volumes. So it's hard to see that Dow Theory has been rendered obsolete.

As Steven Russolillo notes in The Wall Street Journal, it may just be a matter of waiting for a more definitive signal. "For all the chatter about the struggling transports, they've been stuck in a historically tight trading range for much of the year." The gap between the closing highs and lows over the last six months is just 8.31%. That's "the lowest six-month rolling average since 1965", according to Bespoke Investment Group.

Why does that matter? Because it means the transport average is "like a coiled spring ready to burst" the longer such tight range-trading goes on, the greater the chances of a "bigger-than-usual move". Of course, such a move could occur in either direction up or down.

But it's worth noting that, as Hulbert points out, while the Dow Theorists he watches don't all agree, the one with the best ten-year track record Jack Schannep of TheDowTheory.com reckons we're now in a bear market.

It all adds up to another reason why we'd avoid the broad American market for now, in favour of cheaper opportunities elsewhere, such as Europe and Japan.