How Now, Charles Dow?

The oldest and one of the most respected trend following systems in the world is Dow Theory.

Developed by Charles Dow, founder of The Wall Street Journal, Dow Jones and Company and the Dow Jones Industrial Average, Dow Theory is a simple technical trading system using the Dow Jones Industrials and the Dow Jones Transportation Averages. When both averages make new highs, a buy signal is given, and when both averages make new lows, a sell signal is given.

Writing in the Wall Street Journal on January 31st, 1901, Charles Dow compared the ebb and flow of the ocean to the action of the stock market when he said:

A person watching the tide coming in and who wishes to know the exact spot which marks the high tide, sets a stick in the sand at the points reached by the incoming waves until the stick reaches a position where the waves do not come up to it, and finally recede enough to show that the tide has turned. This method holds good in watching and determining the flood tide of the stock market.

In more recent days, the Dow Theory technical trading system went negative in November, 2007, and there was much discussion in financial circles about whether or not this signaled the start of a new bear market. With hindsight always being the best view, clearly Dow Theory got it right as the market continued a protracted decline through the end of the year and 1st Quarter, 2008.

In November, both indexes made new lows and a sell signal was given. Since then, the Industrials have been making new lows but the Transports have been making upward progress and on March 24th reached its first higher high since July, 2007, which was its last “buy” signal.

The Dow Jones Industrial Average has yet to make a new high, and its magic number for a buy signal is a closing high of 12,743. After last week’s rallies that saw an intraday high of 12,790 and a close of 12,654, the Dow Theory system is a whisker away from issuing a new buy signal, and as of Monday’s close, it stood at 12,612, just 131 points from a new buy.

If the Dow Jones Industrial Average can push through and hold above the 12,743 level, Dow Theory says that’s bullish for the market and if not, then the experts say that could set us up for yet another retest of the January lows.

Charles Dow didn’t have a sophisticated trading vehicle like ETFs in his day, but modern day followers of Dow Theory can use ETFs to go both long and short when following Dow Theory.

For investors who want to go long, the venerable Diamonds Trust, Series 1 ETF (DIA) is a great choice and for those who are ultra bullish, Ultra Industrials ProShares (UXI) tracks twice the daily performance of the Dow Jones U.S. Industrials Index. For bears, Short Dow30 ProShares ETF (DOG) gives you 1X short exposure and for ultra bears, UltraShort Dow30 ProShares (DXD) gives you 2X inverse exposure to the Dow Jones Industrials.

So the options are varied and the opportunities plentiful to follow Dow Theory wherever its signals may take you.

Disclosure: none

Comments

[Prosbus]

THREE CORRECTIONS: DDM is ProShares tries to match 2X DJIA. DXD tries to match 2X the inverse of the DJIA. UXI tries to match the 2X the Industrials SECTOR, not the Industrials AVERAGE. They all have a role, both for investors and traders. As usual, read the prospectus carefully!

[JonathanLiss, SAEditor]

Editor's Note: Prosbus, thanks for your first 2 corrections - they have been implemented into the article. However, you seem to be mistaken on UXI. According to ETF Connect (www.etfconnect.com/sel...), an excellent source of ETF and CEF data:

"The Fund seeks daily investment results before fees and expenses that correspond to twice the daily performance of the Dow Jones U.S. Industrials Index."

So it does appear to track the specific index referred to and not just the Industrials sector.

[texan]

I have owned both DDM and UXI and they are not the same, check it at proshares site. DDM is the DOW 30 stocks and UXI is a sector fund with over 250 different industrail stocks. No Financials! No C no BAC. Also UXI is thinly traded with wide spread bid and ask, so DDM is the correct fund for this article.

[locke]

DDM = 2x daily DIA = -DXD

UXI doesn't fit in to this equation.

[johnthebear]

The DJT has a break out above it's 200 day moving average, but I find that inconclusive for the dow theory when matching up with DJI.

Everyone knows the cost of fuel has increased, making trucking very expensive compared with rail, and the index follows the rails. So, how reliable can a theory be that relies on such a distorted indicator? The rails are truly important for measuring industrial activity, but to compare it with current trends does not seem reliable. Please give me your thoughts.

[ponchovilla]

The Dow Theory probably works well with normal tides. If you place a stick in the sand during nor'easter you may not find the stick. Then there are rip tides and tsunami's. The question becomes what kind of tide are we in?

[johnthebear]

ponchovillam,

That was a very good comparison, and so true. I think we are in deep voodoo!

Now it not just a recession" we are in...now they are talking "prolonged recession". What a difference a day makes with the crazy markets these days. UP one day and Down the next, for no real reason. I guess there are a lot of folks with money burning a hole in their pockets and they just don't know what to do? It is my opinion that you should either be short or put your money in a bank with 100,000 government insurance for each deposit. Now is not the time to worry about getting high yields. On the other hand, there is one stock I would recommend. Check out TNH, the only long position I like.