On July 23, 2009, Dow Theory, the oldest and one of the most respected trend following systems in the world, issued a “buy” signal and so that’s worth paying attention to and learning more about how this venerable trading system can confirm other more modern systems you might currently be using.
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 to give buy or sell signals when the action of the two averages confirms the directional change of the market.
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 years, 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 all the way through the spring of 2009.
And now Dow Theory gave a new buy signal indicating its methodology points to higher prices ahead.
Backtesting of Dow Theory indicates that over a more than 70 year period, Dow Theory outperforms buy and hold by roughly 2% per year and does so with less risk, typically underperforming in bull markets and outperforming the market during bear market periods.
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 DIA (Diamonds) are a great choice and other options could be SPY, the SPDR S&P 500 Index, or IWM, the iShares Russell 2000 Index. On the “short” side, you could use SH, ProShares Short S&P 500.
Considering that the S&P 500 at 1,000 is where the index was in 1989, 11 years ago, Dow Theory is certainly worthy of consideration. If you chose to do so, the options are varied and the opportunities plentiful to follow Dow Theory wherever its signals may take you.
To learn more about Dow Theory, you can check out the following resources:
Dow Theory Today by Richard Russell Dow Theory for the 21st Century: Technical Indicators for Improving Your Investment Results by Jack Schannep
Disclaimer: All material herein is believed to be correct but its accuracy is not guaranteed. This article represents solely the opinions of John Nyaradi and readers are encouraged to consult their investment advisors prior to making any investment decisions. All information herein is for general informational and educational purposes only. The information is of an impersonal nature and should not be construed as individualized advice or investment recommendations. There is risk of loss in all trading and readers are encouraged to read the full at http://www.wallstreetsectorselector.com/disclosure.html. None of the information in this article is intended to be investment advice or any kind or offer or solicitation to buy, sell or otherwise invest in any fund, company or security. Nothing herein represents a recommendation, claim, promise, guarantee or warranty regarding the suitability or profitability of any investment.
John Nyaradi is Publisher of Wall Street Sector Selector, an online newsletter specializing in sector rotation trading using Exchange Traded Funds.