My Refute on an article against the Dow Theory

[HenryTo]

Original article here: http://www.leavittbrothers.com//chartspeak/ChartSpeak_032705.pdf

My refute as posted on the Wallstreetbear.com board:
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BearCreek,

I am sorry (and no offense) but as a student of the Dow Theory myself I would say that the entire article is BS and that the author of that article does not have that much of a clue on what Dow Theory is - let alone be an authority on it.

Our website actually contains a pretty detailed rundown of the Dow Theory - but a more detailed version would involve pages and pages of description, theories, and historical backup - and not before you read every single one of the publications published by Charles Dow, William Hamilton, Robert Rhea, E. George Schaefer, and finally, Richard Russell (which spans a period of over 100 years).

Most of the "arguments" put forward by the author against the Dow Theory have been mentioned over the last 75 years. And when all is said and done, Dow Theory has stood the test of time. Perhaps the author just does not have enough of an understanding to use the Dow Theory to his advantage? Or maybe he's just trying to stir up a little bit of controversy?

The primary basis of all of Dow Theory is the concept of values. This has always been emphasized by Charles Dow and from the subsequent students of Dow Theory that I have already mentioned above. The thesis has been to always buy great values and hold it through thick and thin - which brings us to the second most important basis of the Dow Theory.

What is it? That "the market is always to be considered as having three movements, all going on at the same time." and that "The first thing to consider is the value of the stock in which the speculator proposes to trade, the second the direction of the main movement, and the third the direction of the secondary movement (i.e. stocks fluctuate together, but prices are controlled by values in the long run)."

According to Charles Dow, the best way to make money in stocks is to buy good-managed companies at really attractive prices and to hold it through a primary bull market trend.

How do you figure out when the primary trend will end? The movements of the Dow Industrials and the Dow Transports is one methodology but that is only to be used in conjunctions with other methodologies – taking in account such as values, and the phase (there are three phases, according to Charles Dow) of the bull or bear market that one is in. For example, the primary non-confirmation of either the Dow Industrials or the Dow Transports is only useful for calling a top or bottom if we are in the “third and blow off phase” during a bull market or in the “capitulation” phase during a bear market. How can one tell? It is definitely not a science and that’s why it is so fascinating. I do not respect anyone who is trying to strictly break the action of the stock market down into a scientific endeavor.

Okay, let’s now refute the author of the article on a point-by-point basis:

Does it matter that the Dow Industrials do not product any “industrial” products, per se? It is merely a naming convention. At the turn of the century (for example, Disney wasn’t founded until the Great Depression and it would have gone out of business in an environment where people worked six or seven days a week/16 hours a day) the industrial companies represented the backbone of the economy. Companies such as American Beet Sugar, American Can, American Sugar, Anaconda Copper, U.S. Rubber, U.S. Steel, etc. Now, let me ask you this question: Do sugar, iron & steel, copper, and rubber (all commodities in today’s terms) represent the backbone of the American economy today? Hopefully not or we will be living in the “stone age” and the action of the Dow Industrials would not have been so important at all. No, today, the backbone of the economy is represented by, more or less, the 30 “industrial” companies that are the components of the Dow Industrials. Disney does produce a service – that is, entertainment which produces happiness (unless one is a sadist who doesn’t like other people to be happy) and which indirectly drives the economy. So do the financials – not only do they provide the functions to fund American companies or make loans to the U.S. consumer, they also do that function on a worldwide basis, even to foreign governments. And dear author: The transports do not need to be directly shipping the damn products for the companies in the Dow Industrials!! It looks like that the author is trying to debase the Dow Theory based on strict naming conventions involving little details. Well, give me any theory and I can debase it using the methods that this author is using in his article.

Hmmm… the Dow Transports. Whoever said an index has to be perfect? Not Charles Dow and certainly not any student of the Dow Theory that has followed him. In fact, the barometer is not perfect – and this has always been emphasized by Dow and the subsequent Dow Theorists (Hamilton, Rhea, Schafer, and Russell). The action of the Dow Industrials and the Dow Transports are meant to be rough gauges – if you can find any index, indicator, or “system” that is perfect (over the long-run) in this market, I will hand my head to you on a silver platter. The action of the Dow Transports during the last six months with rising oil prices told us a lot about the strength of the economy – i.e. the ability of the economy to withstand rising oil prices. If oil goes down or remain steady and the Transports go down here, then this will definitely be warning us of a slowing economy, for example. If oil prices go up and the Transports go down and vice-versa all of the time, then who needs the Dow Transports as an indicator? Just use the price of oil as your indicator! And surcharges have been in existence since the turn of the century!

Now, let’s talk about WMT. Like I said before, the two indices are not perfect and are only meant to be rough gauges. The Dow Rails did not include any airline stocks until the 1970s and for years, people have been talking about the demise of the Dow Theory and yet true practioners of the Theory has used it to their great advantage since the creation of the airlines. If an index captures 75% of American transportation activity, isn’t that already a good sample of all the transportation activity in the country? The consumer confidence number from the Conference Board only samples 5,000 households, for God’s sake!! Say the index does somehow capture the shipping activity of WMT. Next the author will be complaining that it doesn’t capture the activity of all the newspapers being transported by paper routes headed by 13 year-old kids.

As for volume, Hamilton first mentioned the use of it in his editorials in the WSJ back at the turn of the century. So has Rhea and so has Schaefer and so has Russell in their newsletters. The Theory is in a continual stage of development.

Possibly the only downside is that the companies in the DJIA is price-weighted, and not market cap weighted. But why would a market cap weighted index be a “perfect” index, so to speak? If all of a sudden we have a bubble in entertainment stocks, then DIS would have a huge bearing on the index even though its contribution to GDP may not be as high. In such a scenario, wouldn’t it make more sense to weigh your index by the revenue of each company? But then since we’re trying to gauge the health of these companies as well, shouldn’t we now weigh it by profits or profit margins instead? Take your pick and I will be able to find a flaw in your pick, nonetheless.

Now, I really like this quote: “John Murphy says the Dow Theory misses 20-25% of a move before offering a signal. For very long term traders (we’re talking years) it wouldn’t be bad to nail the middle 50% of a move. But for shorter term trading (holding time = a few days to a few months) we consider missing the first 25% and/or being 25% late with taking profits to be unacceptable.” Time and time again, the Dow Theorists mention that one does and SHOULD not wait for a confirmation from either index to buy or sell. The Dow Theory is a theory based on the observations and interpretations of the action of the stock market over the last 110 years, and IS NOT MEANT TO BE A TRADING SYSTEM! Over time, all trading systems become obsolete – and that is why the Dow Theory has withstood the test of time. If one expects to use the Dow Theory as a trading system in order to make money in the stock market, then he or she shouldn’t be in the stock market.