How now, Dow Theory?

Journal Record, The (Oklahoma City), Mar 9, 1999 by Mark Hulbert N.Y. Times News Service

The Dow Theory market timing strategy -- based on the synchronism, or lack thereof, of the Dow Jones Industrial and Transportation averages -- turned bearish last August. Yet it stayed bearish through the 30 percent rally in stocks in the last quarter and has remained that way during this year's market gyrations.

To be sure, the Dow Theory looked good in the eight weeks after Aug. 4, when it flashed a sell signal; the market dropped a thousand points on the Dow as part of its summer swoon. But the Dow later bounced back and then some; despite its February weakness, it is still up nearly 10 percent since Aug. 4.

Though Dow theorists don't always agree on their interpretations, the Dow Theory newsletters that I monitor are unanimous in advising that investors should act as if they were still in a bear market. To turn bullish, the Dow Theory requires that both the industrial and transportation indexes move higher in strong trends -- and that is currently not the case. When the industrials rallied in January to new highs, the transports lagged behind. At around 3,300, the transportation index is 11 percent below its record high of 3,686 nearly a year ago. (Though investors who follow the theory generally don't spend much time on the underlying logic, it makes sense that in a healthy market the fortunes of manufacturing companies, the industrials, should generally be aligned with those of the companies that ship their goods, the transports.) Tracking this divergence between the indexes is all well and good, say many frustrated adherents of the Dow Theory. But, having been on the sidelines during the fall and winter market rally, they have a burning question: Should they keep following a theory that has been so out of sync with the recent market? Or would sticking with it be an example of what Ralph Waldo Emerson meant when he described the foolish consistency that is the hobgoblin of little minds? Sooner or later, all investors confront such questions about their strategies. After all, no system makes money in all market environments. What to do? Try standing back from your short-term frustration by focusing on long-term performance. Make sure your strategy has proved itself over many years and in different situations. In no event should you judge its performance over anything less than five years. And even that may be too little if, like the last five years, the period hasn't encompassed a full market cycle. After evaluating your system over the long term, you may conclude that you shouldn't have adopted it in the first place. But if you originally chose your strategy based on its long-term returns, the chances are good that recent performance won't justify throwing in the towel. You should dump your system only if you wouldn't choose it all over again. If adherents to the Dow Theory studied its record, they would likely stick to their guns. Its long-term performance has been superb, even if it missed the market's strong rally late last year. Consider the performance of Dow Theory Letters. The best-known such newsletter, it has been applying the theory, as interpreted by its editor, Richard Russell, for more than 40 years. Since mid-1980, when the Hulbert Financial Digest began monitoring the newsletter industry, a portfolio that followed Russell's signals, switching between a stock index fund and Treasury bills, gained an average of 13.5 percent annually. Though this is less than the 16.8 percent that would have been produced by buying and holding, Russell's return was produced with 37 percent less risk. On a risk-adjusted basis, in fact, Russell's timing advice has actually beaten the market. Yes, the newsletter's current performance today doesn't look as good as it did last fall. But Russell's long-term track record is still excellent. Assuming that you're following the Dow Theory because it reduces risk while furnishing competitive long-term performance, you have no reason not to stay the course. Mark Hulbert is editor of the Hulbert Financial Digest, a newsletter based in Alexandria, Va.