Dow Theory

Confirmation

Dow split industrial stocks and railroad stocks into two separate averages. His theory requires that movements on one average be confirmed by the other:

• A bull market starts when a bull trend on one average is confirmed by the other average commencing a bull trend.
• A bear market commences when a bear trend on one average is confirmed by the start of a bear trend on the other average.

The Railroad average has declined in significance over the years and the Dow Jones Transport Average is now used in its place.

Example

Dow Jones Industrial Average is compared to the Transport Average.

1. The Transport Average fails to confirm the lower High and Low on the Industrial Average. The bull market is intact.
2. The end of the bull market is confirmed by the lower High and Low on the DJTA and a large correction on the DJIA.
3. Higher Highs and Lows on both averages confirms the resumption of the bull market.

Using The S&P 500 As An Alternative

Railroads have declined in importance since the early 1900s when they dominated the stock market. The Transport Average has been expanded to include freight companies such as UPS and Fedex, airlines such as Southwest and Continental, and shipping companies such as OSG. Nevertheless, the index has declined in significance and many traders instead use the broader Standard & Poors 500 index to confirm Dow Industrial signals.

Using the Dow

It is not an infallible system for beating the market ~ Robert Rhea.

The Dow Theory was created as a leading indicator of the business cycle. It should merely be used to indicate the direction of the primary trend — to be followed when trading individual stocks.

Market Phases

Primary movements have three phases. Look out for these general conditions in the market:

Bull Markets

• Bull markets commence with reviving confidence as business conditions improve.
• Prices rise as the market responds to improved earnings
• Rampant speculation dominates the market and price advances are based on hopes and expectations rather than actual results.

Bear Markets

• Bear markets start with abandonment of the hopes and expectations that sustained inflated prices.
• Prices decline in response to disappointing earnings.
• Distress selling follows as speculators attempt to close out their positions and securities are sold without regard to their true value.

Dividend Yield

Dow believed that stocks yielding below 3.5 percent where over-priced "except there be some special reason." Richard Russell analyzed the dividend yield on the Dow from 1929 to 1959 and found that the market tended to reverse when yields had fallen to between 3 and 4 percent.

Since the 1960s the dividend yield on the Dow and S&P 500 has declined to around 2 percent. We should be careful not to leap to the conclusion that the market is way over-valued. Examine the S&P 500 chart below and you will observe that the Dividend Payout Ratio declined over the same period, from 60 to 30 percent.

Companies are retaining a higher percentage of earnings, preferring to return capital to stockholders by way of share buy-backs rather than by way of dividends. This favors investors who prefer the enhanced earnings growth offered by share buy-backs, without the tax implications associated with dividends.

We should therefore switch our focus to earnings yield, rather than dividend yield, in order to avoid any distortion. An earnings yield of below 5.0 percent would offer a similar over-bought signal to a dividend yield of less than 3.5 percent (0.035/0.7=0.05). This translates to a price-earnings (PE) ratio above 20. I use a PE ratio above 20 to signal that a bull market is entering stage 3.