The Dow Theory Revisited

From late October through December of 1973 stock prices persistently declined. The Dow Jones industrial average, which stood at 980 in October, fell below 800 in November. During the same period the Dow Jones transportation average fluctuated within a narrow range. Toward the close of the decline in the industrial average, investors noted that the financial press and current periodicals mentioned the "Dow Theory" in many of their stock market articles. A number of readers who scanned references to "confirmation" of the Dow Jones averages and "divergence" between the industrial average and transportation average must have wondered what the Dow Theory was all about and its degree of usefulness to those engaged in equity investment and speculation.

The Dow Theory as known and discussed in financial circles today is actually the result of a long evolutionary process, consisting of a number of milestones. The first of these was the contribution of Charles H. Dow (1851-1902) to stock market theory.

Dow was one of the foremost financial journalists of his time. In him we find no financial visionary evolving a Monte Carlo system of beating the stock market, but a newspaperman of the highest standing who learned his trade under the leadership of Samual Bowles, one of the newspaper giants of all time. Dow's writings in THE WALL STREET JOURNAL, of which he was founder and first editor, showed a firm grasp of economic theory, domestic and international banking, corporate financial practices, financial and economic history, as well as stock market theory and practice. His work on the JOURNAL firmly established his reputation as a financial journalist. He is also generally given credit for compiling the first average of stock prices. [1]

THE WALL STREET JOURNAL first appeared on July 8, 1889, with Dow as editor, and has been a part of the financial scene ever since. Dow's many paragraphs appeared in the paper until shortly before his death on December 4, 1902. In conformity with prevailing newspaper practice, Dow did not identify his writings. However, it is possible to establish the identity of his writings for the period April 21, 1899, to October 25, 1902, inclusive. [2]

Dow's editorials covered many subjects. His views on the business cycle were advanced for the times and there is no doubt much of the later theoretical interpretation of business cycles developed by economists drew basic data and support from the daily writings of Dow and other early financial journalists. [3]

There is a very strong possibility that Charles H. Dow did not formulate a stock market "theory" as such. Dow's editorials embraced many subjects, with investment and stock market speculation prominent among them. It is, of course, impossible to learn to what extent Dow's readers looked upon his editorials as setting forth a stock market theory. The editorials were almost a daily feature of THE WALL STREET JOURNAL, and no doubt greater emphasis was placed on certain editorials by some readers who, in turn, gave less attention to others. Those editorials which contained suggested methods of trading in stocks probably acquired a following.

"DOW'S THEORY" EMERGES

In 1902 Samuel Armstrong Nelson added THE ABC OF STOCK SPECULATION as Volume V in Nelson's Wall Street Library, a series of books concerned with the stock exchange. [4] Nelson had endeavored to have Dow write the book but his efforts were unavailing. As a result he undertook the work himself, using selected editorials written by Dow, and previously published in THE WALL STREET JOURNAL, as the basic framework for the book. Of the 35 chapters that comprise THE ABC OF STOCK SPECULATION, 17 consist of editorials written by Dow, and 15 of these chapters were designated by a footnote as "Dow's Theory." Evidently, this was the first use of the term in print. Thus, the Dow Theory was originally named in footnotes incorporated in a work on speculation in common stocks, hardly an auspicious beginning for an appellation that has endured in the language of the market place to the present day.

In this manner S.A. Nelson first named the theory, and was the first "Dow Theorist" in print. However, Nelson cannot be classified as an exponent of the Dow Theory—other than for his role in the selection of Dow's editorials—since he did not add by way of interpretation to the words of Dow.

The editorials selected by Nelson contained many principles that could be utilized by investors and speculators engaged in investing and trading in common stocks. Dow advised his readers to be conservative, to avoid buying on margin in larger amounts than prudent considering their resources, and to have an idea of the value of the stocks they purchased. In this last respect Dow wrote along the lines of what today is classified as security analysis.

For the stock market trader, Dow discussed the maxim—"Cut your losses short, but let your profits run"—and the placing of stop orders. He likewise devoted many paragraphs to the two general methods of trading in stocks, namely, trading in relatively large amounts coupled with the use of stop orders and buying on a scale down, or averaging purchases as a stock declines. It should be noted that this is not the same as dollar averaging.

However, Dow's contributions to stock market thought by his classification of three movements in the market and the formulation of the law of action and reaction no doubt caused a great deal of discussion among the readers of Nelson's volume. Dow stated there were three movements in the market—all going on at the same time. The first was the daily fluctuation; then the short swing ranging from about 10 to 60 days, and finally the main movement covering at least four years in duration. Dow was a firm believer in the periodicity of the business cycle and felt that the first action of a trader should be to ascertain if a bull or bear market was underway. This was reflected, of course, by the direction of the main movement over an extended period of time. As an aid in determining the main movement, Dow developed the famous "Dow Jones Averages."

The law of action and reaction applied to movements in individual stocks as well as the general equity market as reflected by a stock average. It was a rule that a primary move would have a secondary movement in the opposite direction of at least three-eighths of the primary movement. Apparently both the concept of the three movements in the market and the law of action and reaction were original with Dow.

Shortly after the publication of THE ABC OF STOCK SPECULATION, S.A. Nelson died and the book went out of print. It was only republished at a much later date, but remained available in libraries and secondhand bookstores.

A THEORY OF FORECASTING

The first great exponent of the Dow Theory, William Peter Hamilton, next appeared upon the scene. He was a Scottish journalist who served as editor of THE WALL STREET JOURNAL from January, 1908 until his death on December 9, 1929. Hamilton joined the staff of the JOURNAL in 1899 and worked under Dow's editorship until the latter's death. There is no proof that Hamilton was ever a close associate of Dow, as many writers hold; rather, the evidence indicates that their relationship was that of employer and employee and editor and reporter. He presented his version of the theory not only in THE WALL STREET JOURNAL but in BARRON'S and in a book, THE STOCK MARKET BAROMETER, published in 1922. From that time until his death Hamilton was looked upon as the leading exponent of the Dow Theory.

The Hamilton version of the Dow Theory is the "Dow Theory" known and discussed in financial circles today. In short, Hamilton presents the view that prices on the stock exchange take account of all known facts and discount business conditions. The Dow Jones averages are representative of stock exchange prices and hence discount business conditions. Hamilton also stressed the "confirmation of the averages" and the action of a "line formation" in the averages. [5]

Dow saw the stock market as a part of the entire economic system and approached the problem of investing and trading in common stocks by a study of current economic conditions, an analysis of the position of the general equity market and of individual stocks within the market, as well as a financial analysis of the corporations concerned. Hamilton, however, extended the general observations of Dow into a theory of forecasting both the stock market and economic events. It is important to note the transition from the principles and rules on speculation and investment approach as presented by Dow to the forecasting approach of William Peter Hamilton.

After Hamilton's death no advocate of the Dow Theory came forward to command recognition until Robert Rhea published a series of articles on the subject in BARRON'S in 1932. That same year Rhea published THE DOW THEORY which canonized Hamilton and firmly established the Hamilton version of the Dow Theory as standard. Rhea's volume, with its keen analysis of Hamilton's editorials, did much to revive an interest in the theory which had suffered an almost fatal thrust by the general disillusionment that accompanied the deflation of the bull market in the years 1929-1932. [6]

From 1932 until his death in 1939, Robert Rhea was looked upon as the leading exponent of the Dow Theory and there is no doubt he did much to popularize and publicize it. His stock market service published a series of letters entitled DOW THEORY COMMENT in which he traced the performance of the Dow Jones industrial and railroad averages and discussed the various movements with respect to the primary and secondary trends of the market. The DOW THEORY COMMENT letters reached 6000 subscribers.

Rhea's book, THE DOW THEORY, takes the form of a manual or a compendium in which Rhea compares quoted portions of Hamilton's editorials, or passages from THE STOCK MARKET BAROMETER, with the various tenets of the Dow Theory. Rhea's original contributions are at a minimum, but they are very effective when they appear. His great contribution to the Dow Theory is the manner in which he sets forth the tenets in a single listing and clearly defines each concept; his primary achievement is one of classification. There is no doubt that he performed his declared task, that of formulating the Dow Theory, through a study of the writings of Hamilton in a competent manner. As for the work of Charles H. Dow, Rhea was not really familiar with it, and he made no pretense to the contrary.

Any attempt to fuse the writings of Dow and those of Hamilton and Rhea into a concordant theory presents many difficulties. It must be remembered that Dow was a journalist writing timely articles on matters that were of current interest to his readers. Hamilton, however, in THE STOCK MARKET BAROMETER, and Rhea, in THE DOW THEORY, presented a formalized theory of market forecasting.

In short, the evolution of the Dow Theory consisted of four steps: first, the original editorials of Charles H. Dow; second, the compilation by Nelson of Dow's editorials in THE ABC OF STOCK SPECULATION; third, Hamilton's emphasis on the confirmation of the averages, line formations in the averages, and the use of the action of the market as a forecasting device; and fourth, Rhea's acceptance of the Hamilton version of the Dow Theory and his placement of the various tenets of the Dow Theory in definitive form.

THE DOW JONES AVERAGE

Dow's compilation of an average of stock prices in 1884 was one of the great contributions to stock market methodology. Dow computed the average, or the arithmetic mean, of stock prices by adding the prices of the stocks included in the specific average, and dividing the figure by the number of stocks so used. He did not use a weighted mean, or make adjustments of any other nature. There is no evidence that Dow looked upon the averages as containing anything more than an indication of a statistical nature of the trend of the stock market as a whole. It was for this reason that Dow found it desirable to include "active" stocks (i.e., those stocks with a large volume of transactions) in the averages.

The Dow Jones averages remained averages, or arithmetic means, throughout Dow's lifetime. Therefore, he was not concerned with adjustments for stock splits as is the case with the Dow Jones averages today. Dow did substitute one stock for another in the averages and to this extent attempted to have the averages reflect the trend of the market under changing conditions.

The present Dow Jones averages are not averages but are indexes. The industrial average of 30 stocks began on October 1, 1928 and was calculated by adding the closing prices of the 30 stocks concerned and dividing by 16.67. This divisor was arrived at by adjusting for stock splits and stock dividends. A constant division was used for the first time on September 10, 1928 when the industrial average contained 20 stocks. Prior to that time an attempt was made to compensate for stock splits by applying a multiplier to the individual stocks concerned, i.e., the closing price of American Can would be multiplied by 6, that of General Electric by 4, etc. The divisor has been changed many times to adjust for stock splits and stock dividends since, and at the time of writing is 1.626.

The transportation average was introduced on January 2, 1970 and was devised to replace the railroad average. It includes the stocks of railroads, airlines, and other corporations concerned with the transportation industry. There are 20 stocks in the average and the divisor at the time of writing is 3.231.

The validity of the Dow Jones averages as a proper measure of overall market movements has been questioned due to the relatively small sample used. Two other criticisms often advanced are the lack of weighting by size of capitalization of the corporations concerned and the change of a stock's weight in the sample due to major changes in capitalization. Likewise, the substitution of stocks in the averages over time has also received critical attention.

Those who defend the use of the averages point out that the selection of the stocks in the averages is not a random one and the corporations included by their stock issues represent large businesses. As a result the averages do not include marginal concerns or special situations. Likewise, the Dow Jones averages are still the gauge of the overall market to a great number of investors and speculators and their long historical record makes it possible to use them for comparison purposes.

PREDICTION VALUE

Has the Dow Theory successfully predicted bull and bear markets making it possible for Dow Theorists to profit thereby? Evidence that this is the case has been accumulating for 40 years. Alfred Cowles III read a paper before a joint meeting of the Econometric Society and the American Statistical Association in Cincinnati, Ohio, on December 31, 1932. This paper was concerned with the stock market forecasting records of 20 fire insurance companies, 16 financial services, 24 financial publications, and the Dow Theory forecasting record of William Peter Hamilton from December 1903 to December 1929. [8]

With respect to Hamilton's record Cowles states:

From December 1903 to December 1929, Hamilton, through the application of his forecasts to the stocks comprising the Dow Jones industrial averages, would have earned a return, including dividend and interest income, of 12 per cent per annum. In the same period the stocks comprising the industrial averages showed a return of 15.5 per cent per annum. Hamilton therefore failed by an appreciable margin to gain as much through his forecasting as he would have made by a continuous outright investment in the stocks comprising the industrial averages. He exceeded by a wide margin, however, a supposedly normal investment return of about 5 per cent. Applying his forecasts to the stocks comprising the Dow Jones railroad averages, the result is an annual gain of 5.7 per cent while the railroad averages themselves show a return of 7.7 per cent. [9]

Justin F. Barbour in an article in THE ANALYSTS JOURNAL disputes the methodology used by Cowles. [10] He argues that had the period of study been from December 1903 to December 31, 1932 the return on a continuous investment would have been far less, and Hamilton's gains would have been substantially greater. Cowles was unfortunate in his selection of the period of time included in the study by concluding it with Hamilton's death on December 9, 1929.

Hamilton's famous "A Turn in the Tide" editorial appeared in THE WALL STREET JOURNAL on October 25, 1929 in which he advised his readers that the great bull market was over. Hamilton concluded in this editorial that "together the averages gave the signal for a bear market in stocks after a major bull market with the unprecedented duration of almost six years." Since Cowles' methodology assumed Hamilton sold short when he was bearish and covered only when he became doubtful or bullish it does not appear reasonable to assume that Hamilton would have covered his short position in December 1929, had he lived, considering the action of the averages during that month.

In 1944 Cowles continued his study on stock market forecasting and extended the records of 11 of the forecasters who had been the subject of his research published in 1933 in ECONOMETRICA entitled "Can Stock Market Forecasters Forecast?" Cowles did not identify the forecasters but states: "These organizations are well known. Names are omitted here because their publication might precipitate controversy over interpretation of the records. The wording of many of the forecasts is indefinite, and it would be frequently possible for the forecaster after the event to present a plausible argument in favor of an interpretation other than the one made by a reader." [11]

Cowles found that the forecasting agency with the most successful record for the period from 1928 to 1943 could be extended back to 1903. He explains as follows:

While three individuals were for different periods responsible for the forecasts through these 40 years, the general principles followed by them all were similar and the succeeding forecasters were avowed disciples of their predecessors. It therefore seems justifiable to treat the combined record as a continuous one for the 40 years in question. [12]

Who were these three individuals? Justin F. Barbour identifies them as William Peter Hamilton, Robert Rhea, and Perry Greiner. [13] Therefore, the method used by these individuals was the Dow Theory as all are recognized as Dow Theorists. Recently Perry Greiner extended the forecasting records according to the Dow Theory to seventy years. [14]

We have revisited the Dow Theory and although the writer will not forecast what the future holds for it, he will repeat a thought he has previously expressed in print. In the history of stock market thought, Dow's place is of similar importance to that of Adam Smith in the field of economics. If this is so then the Dow Theory will be revisited time and time again in the future.

Professor Bishop holds the A.B. degree in History from the College of William and Mary and the M.B.A. and Ph.D. degrees from New York University. He had an extensive business career, which included twelve years employment with Merrill Lynch, Pierce, Fenner and Smith. He taught finance at the University of Tennessee, Knoxville, Tennessee, from 1959 through 1964. Since September 1965 he has been Professor and Chairman, Department of Finance, Northern Illinois University at DeKalb, Illinois. Professor Bishop is the author of CHARLES H. DOW AND THE DOW THEORY; editor of CHARLES H. DOW: ECONOMIST; a contributor to COLLIER'S ENCYCLOPEDIA and THE ENCYCLOPEDIA BRITANNICA, and author of many articles in the learned journals and popular publications.

NOTES AND REFERENCES

[1] For an account of Dow's life and work see George W. Bishop, Jr., CHARLES H. DOW AND THE DOW THEORY (Appleton-Century-Crofts, Inc. 1960).

[2] Dow wrote the "Review and Outlook" column in THE WALL STREET JOURNAL during this period.

[3] For a selection of Dow's writings on business cycles see George W. Bishop, Jr. (Ed.), CHARLES H. DOW: ECONOMIST (Dow Jones Books 1967).

[4] The book first appeared on December 24, 1902 and has been republished in several editions since that time. Dow did not live to see the completed work since he died on December 4, 1902.

[5] Confirmation of the averages means that when the Dow Jones industrial or railroad (transportation) average moves into new high or low ground the other average must do likewise for the movement to have significance. The Dow Jones public utility average is not considered. A "line formation" in the averages means a horizontal movement in both averages within a narrow range. The movement must continue for a number of weeks according to Hamilton, but he placed no limit on the extent of the range. Robert Rhea places the range at "approximately 5 percent" and places the time limit at "two or three weeks or longer."

[6] Rhea reprints as an Appendix in THE DOW THEORY a total of 260 editorials from the pen of Hamilton. Of these 212 appeared in THE WALL STREET JOURNAL and 48 were published in BARRON'S. They span the years 1903 to 1929, inclusive. Professor Henry B. Kline of the English Department in the University of Tennessee assisted Rhea in identifying the articles. Kline died in 1951.

[7] For a technical discussion of the construction of stock price indexes and criticisms of well-known indexes, including the Dow Jones averages, see COMMON-STOCK INDEXES, Cowles Commission for Research in Economics, Monograph No. 3 (Principia Press, Inc. 1939).

[8] ECONOMETRICA, Journal of the Econometric Society, Vol. 1, July 1933, pp. 309-24.

[9] Id. at p. 315.

[10] Barbour, "An Analysis of the Conclusions of the Cowles Studies with Respect to the Dow Theory," THE ANALYSTS JOURNAL, Vol. 4, Fourth Quarter 1948, pp. 11-20.

[11] Alfred Cowles III, "Stock Market Forecasting," Cowles Commission Papers, New Series, No. 6, 1944, p. 206.

[12] Id. at p. 210.

[13] Barbour, note 10 supra, p. 11.

[14] Perry P. Greiner & Hale C. Whitcomb, THE DOW THEORY AND THE SEVENTY-YEAR FORECAST RECORD (Investors Intelligence, Inc. 1969).