Annals of the

University of North Carolina Wilmington

International Masters of Business Administration

http://csb.uncw.edu/imba/

THE DOW THEORY: A HISTORICAL TEST AS INTERPRETED BY RICHARD RUSSELL

STEFAN P. SIDERIS

A Thesis Submitted to the University of North Carolina Wilmington in Partial Fulfillment

of the Requirements for the Degree of Masters in Business Administration

Cameron School of Business

University of North Carolina Wilmington

2008

Approved by

Advisory Committee

William Sackley Ravija Badarinathi

Joe Farinella Chair

Accepted by

_________________________ Dean, Graduate School

ii

TABLE OF CONTENTS

ABSTRACT ............................................................................................................................. iii

LIST OF FIGURES .................................................................................................................. vi

LITERATURE REVIEW............................................................................................................3

Market Efficiency....................................................................................................................3 Market Anomalies ...................................................................................................................6 Technical Analysis ..................................................................................................................8 Behavioral Finance................................................................................................................11

THE DOW THEORY ...............................................................................................................14

Origins ..................................................................................................................................14 Basic Tenets of Dow Theory .................................................................................................17

A HISTORICAL COMPARISON OF THE AVERAGES.........................................................25

Dow Jones Industrial Average (DJIA) ...................................................................................25 Dow Jones Transportation Average (DJTA) ..........................................................................26 Ten years of the Dow Theory ................................................................................................27

RICHARD RUSSELL: A REVIEW..........................................................................................30

Technical Indicators: Russell’s Top Five ...............................................................................31

METHODOLOGY....................................................................................................................33

Dow Theory Event Study ......................................................................................................33 Hypothetical Portfolio: measuring Dow Theory vs. the S&P 500...........................................34

RESULTS.................................................................................................................................35

CONCLUSION.........................................................................................................................40

REFERENCES .........................................................................................................................42

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ABSTRACT

The Dow Theory is undoubtedly one of the oldest investment strategies in the history of

capital markets. Since being revealed in year 1900 by way of Charles Dow’s editorials, his ideas

have been passed down by market practitioners willing to learn and practice the facets of the

theory. The Dow Theory, simply stated, can be defined as a study of market index averages in

an effort to understand the primary trend of a market. In broader terms, it is technical analysis.

In the era of the 21 st century, the foremost practitioner of the Dow Theory is Richard Russell. By

use of Richard Russell’s editorials written for his investment service since 1964, a test of the

effectiveness of the Dow Theory was performed. An event study and a simulated portfolio

modeled after Richard Russell’s interpretation of the Dow Theory yielded interesting results.

Although the Dow Theory was unsuccessful in producing a significant alpha measurement, the

Theory’s ability to time bull and bear market cycles draws interest to the 100 year­old theory

even in today’s markets.

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ACKNOWLEDGMENTS

I offer the utmost appreciation to Mr. Michael Gan, who was an intricate part of the

completion of this thesis. Michael offered valuable advice and support though the finishing of

this document and I’m tremendously grateful for his insight. Michael has always been a keen

follower of the Dow Theory, and the writings of Richard Russell. I’m appreciative for his

willingness to present me with the opportunity to study the intricacies of the theory as well as

read the always interesting editorials written by Richard Russell. Thanks Mike!

Also, I bid many thanks to my thesis committee, who offered constant assistance in the

completion of this thesis. The underlying heart of this paper stems back to numerous theories

and topics discussed in class, where my committee so diligently educated, yet also, intrigued me

to further investigate these class discussions with this thesis.

Finally, one last thanks to Mr. Richard Russell and his 50 years of valuable market

insight. Without his interpretations of the Dow Theory, this thesis would not be possible.

v

LIST OF TABLES

Table Page

1. Comparison of DJIA Components ............................................................................. 26

2. Comparison of DJTA Components............................................................................ 27

3. Summary of Portfolio Comparison Metrics .............................................................. 38

vi

LIST OF FIGURES

Figure Page

1. The three stages of a Bull market................................................................................... 20

2. DJIA 10 Year Price Movement..................................................................................... 29

3. DJTA 10 Year Price Movement .................................................................................... 30

4. Annual Portfolio Return Comparison ............................................................................ 36

5. Annual Portfolio Return Comparison ............................................................................ 37

6. Dollar Return Comparison............................................................................................. 39

INTRODUCTION

The Dow Theory is irrefutably one of the oldest strategies in investing, having

survived the trials and tribulations of the market place for over 100 hundred years. It is

accredited with the birth of modern day technical analysis and is regarded among many as a

powerful tool for predicting stock market movements. Subsequent to pioneering and providing

the investment world with the development of the Dow Jones Industrial and Transportation

averages, Charles H. Dow began to note fundamental characteristics on index price movements.

Dow’s initial work, which was published in the Wall Street Journal during the years of 1900­

1902, provided the basis for the renowned Dow Theory. With a continued effort by his

predecessors, S.A. Nelson, William Peter Hamilton, Robert Rhea, and E. George Schaefer, the

insights of Charles Dow were shaped into an applicable market theory. While known among

many of Wall Street’s finest investors and analysts today, surprisingly, the Dow Theory has

received little attention in recent years resulting in sparse academic research on the topic. Yet,

the Dow Theory is attributed with assisting in some of the most famous market calls in the

history of stock market speculation. Through his interpretation of Dow Theory, Peter Hamilton

predicted the culmination of the 1921­1929 bull market written in an editorial for Barron’s. In

what has become his most famous editorial, Hamilton wrote in “A Turn in the Tide,” October 25,

1929 (Hamilton, 250), that the great bull market was ending and a bear market was to begin.

Furthermore, Robert Rhea called the exact bottom of the bear market on July 8, 1932. However,

were these market calls the result of lucky guesses, or an outcome of tactful market timing? This

thesis intends to test these very questions by investigating the reliability of The Dow Theory.

Despite being founded over 100 years ago, Dow Theorists and practitioners can still be

found practicing in today’s markets. Through the interpretations of Richard Russell, an

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accredited analyst and lifelong student of the theory, I will analyze the effectiveness of the Dow

Theory. Richard Russell has been the foremost scholar to the Dow Theory in recent years, and

has over 60 years of financial expertise where he has diligently applied the Dow Theory to his

investment decisions. To test the theory, I will use 33 years of editorials published by Russell,

amounting to nearly 830 articles between the years 1975­2008. The market data collected from

the editorials will be analyzed using a simulated portfolio, as well as an event study test, where a

conclusion will be inferred per the results of the developed models. This market study will

closely follow the previous academic research of Brown, Goetzmann, and Kumar (1998) and

their article, “The Dow Theory: William Peter Hamilton’s Track Record Reconsidered.” It is

important to note that the aim is not to recreate the work of Brown, Goetzmann, and Kumar, but

merely to utilize their previous study as a template to devise unique results pertaining to the Dow

Theory as interpreted by Richard Russell. The Dow Theory is regarded as the backbone for all

technical analysis and ascertaining its success in financial markets would be vital in the debate of

financial market efficiency. Therefore, this thesis not only serves to validate Dow Theory, but

also, in doing so, may offer evidence challenging the validity of efficient capital markets.

3

LITERATURE REVIEW

The fundamental driving forces which cause market movements have been an

ongoing debate in the financial world for years. Are market movements random? Do investor

emotions affect stock values? Can the market be predicted and timed? Do past prices matter?

These are a handful of questions that have beleaguered investors for years and, unfortunately,

definitive answers have yet to be found. Every year, countless investors buy and sell financial

instruments in hopes of creating wealth. Some believe that markets are efficient and that prices

follow a random, unpredictable path. These investors are firm believers that the markets rule and

excess returns can’t be captured. However, there is an entire other breed in the investing world

who strongly believes that markets are inefficient and that profits can be taken from market

anomalies. The following sections will offer a review on the critical topics of market efficiency,

market anomalies, technical analysis, behavioral finance, and lastly, the Dow Theory.

Market Efficiency

Many investors question the credibility of predicting market movements and defer to

the efficient market hypothesis and the random walk theory. The idea of market efficiency

began in the beginning of the 20th century with a dissertation written by Bachelier (1900), where

he described the discounting of past, present, and future market events in stock prices. However,

the studies of Bachelier were unnoticed for many years until being republished and discussed by

Cootner (1964). Nonetheless, informational market efficiency was first popularized with the

paper, “Efficient Capital Markets: A review of Theory and Empirical Work,” authored by

Eugene Fama in 1970. In his paper, Fama reviews previous random walk literature as well as

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prior tests of market efficiency. He concludes that three distinct levels of informational

efficiency exist within financial markets: weak form, semi­strong, and strong form. The weak

form of market efficiency proposes that prices reflect all past information. The semi­strong form

of market efficiency claims that prices assimilate all relevant public information as well as all

past information. Strong form efficiency asserts that prices reflect all public and private

information, dismissing the ability of insider trading. The implications of market efficiency for

investors are an inability to predict stock returns and generate abnormal profits. Consequently,

prices can be described as unpredictable and indiscriminate, appearing to move in a “random

walk,” as described by Malkiel (1973) in his book, “A Random Walk Down Wall Street.”

According to Malkiel, all relevant information is sudden, unobstructed, and quickly reflected in

stock values. Therefore, stock prices will move in a random path in accordance with the content

of daily news. Hence, he advocates a buy and hold strategy, while dissuading the use of

technical and fundamental analysis. Multiple tests have been conducted to determine the validity

of these types of market efficiencies.

Market efficiency at its simplest form is weak form efficient. The weak form asserts

that all past market prices and data are reflected in a stock’s value and therefore past information

is of no use or value in financial decision making. By definition, weak form market efficiency

refutes and discourages the effectiveness of technical analysis. There have been several studies

aimed at weak form market efficiency where, considering a low degree of serial correlation and

transaction costs, weak form efficiency holds true. These studies all concluded that past price

information was irrelevant in present day price movements and there was little predictive power

in past prices. Weak form efficiency was tested on 22 UK stock and commodity price series

(Kendall, 1953). According to Kendall, the price series moved in random changes from one term

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to the next. He wrote, “The data behaved almost like a wandering series.” This evidence later

became known as the random walk theory.

Tests of the semi­strong form of market efficiency are typically conducted with a

consideration of market reaction to public announcements such as stock splits, earnings, dividend

increases, etc. A major implication of the semi­strong form would in discrediting the use of

fundamental analysis in investment decision making. Fama, Fisher, Jensen, and Roll (1969)

developed an event study to test the change in price with regards to company stock splits. They

found that market sentiment expected the news and consequently, resulted in price adjustment

and the majority of price movement was completed before the announcement. Upon the official

announcement, any price change that was not previously anticipated by the market, was quickly

noticed and reflected in the stock price.

Strong form market efficiency is typically tested using fund managers’ performance. It is

thought that professionals have the most tradable knowledge, which at times is not readily

available to the public. If profitable, this would be a violation of strong form efficiency. The

earliest study of an investment professional unable to beat the market was offered by Cowles

(1933). However, this study was later disproven by Brown, Goetzmann, and Kumar (1998) in

their retest of Cowles’ data citing the lack of risk adjusted returns. Nonetheless, upon the

development of the Capital Asset Pricing Model by Treynor (1961) and Sharpe (1964 ),a valid

benchmark for fund manager performance was available. The foremost paper testing the strong

form of market efficiency was authored by Jensen (1968). In his paper, Jensen studied the

performance of 115 mutual funds over the period of 1955­1964. He finds that any advantage

that the managers may have, is consumed by fees and expenses. It is noted by Grossman and

Stiglitz (1980) that it is impossible for the efficient market hypothesis to formally dismiss small

6

abnormal returns before considering fees and expenses. They continue to discuss that any

rational market model must incorporate some ability for security analysis thereby acknowledging

some marginal error in a market’s ability to be 100 percent efficient.

Market Anomalies

In contrast to efficient markets, the ability to create returns superior to that of the

market would be categorized as abnormal returns as a result of market inefficiency. In an

inefficient market, prices are slow to move towards their actual values particularly as a result of

irrational investor behavior. According to a supporter of inefficient markets, these inaccurate

market prices, known as market anomalies, pose opportunities to seize profits in excess of

market returns by use of tactful investing strategies.

While many professional tactics are unknown, a handful of academic papers have

uncovered market strategies which claim to profit due to market inefficiencies. The size­effect,

the turn of the year or January effect, the weekend effect, and the momentum effect are among

the most prominent anomalies researched. Strong believers in the anomalies will claim that

these strategies have beaten the market and thus offer proof of market inefficiencies. It should

be noted that in most cases, market anomalies are quickly removed from markets as practitioners

quickly arbitrage away their effectiveness. However, even if these anomalies are no longer

exploitable, the fact that they were once exploitable offers evidence contrary to market

efficiency.

The small­firm effect became popular when Reinganum (1981) demonstrated that

small capitalization firms on the NYSE posted average returns superior to Capital Asset Pricing

Model calculations as developed by Sharpe and Litner(1965).

7

The January effect was first noticed by Haugen and Lakonishok in 1987 and

presented in their book, “The incredible January effect,” offering evidence for market

inefficiency. According to Haugen and Lakonishok, small­cap stocks appear to have larger than

usual gains at the end of the year, from December to January 5, where willing investors can

capture abnormal returns. They describe this occurrence as the result of depressed stock values

from year­end selling. This year end selling comes from investors realizing capital gains, selling

losses for tax purposes, portfolio window dressing, and raising holiday cash. This increased

selling depresses stock values to attractive lows resulting in a January rally. Most market

anomalies, once discovered and recognized, are typically arbitraged away by market

practitioners. However, Haugen re­explored the January effect and discovered its existence in

financial markets 17 years later (Haugen and Jorian 1996). They cite that the January Effect may

still be in place because of significant risk associated with exploiting it.

The weekend effect describes an anomaly where prices on Monday tend to be less

than those of the preceding Friday. Academics have explained this phenomenon by citing that

companies tend to release bad news on Fridays. Others have taken the behavioral route by

explaining that it results from fading optimism over the weekend. Lakonishok and Maberly

(1990) found that the majority of individuals tend to increase their trading volume on Mondays,

most of which is selling activity. The market is unable to absorb the large number of open

shares, which results in a price decline. The idea is that an individual’s time to think about a

buying or selling situation frequently occurs during the weekend and therefore increased trading

can be seen on Mondays.

The momentum effect or momentum strategy is a tactic where an investor looks to

capitalize on the existence of a continuing trend in the market. Momentum investing is the belief

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that large increases in value will continue to be followed by appreciating prices as the

“momentum” continues to swing upward. It is a trend following idea of investing. This type of

investing is similar to the aim of technical analysis, to look for and define the current trend and

trade with the trend until it changes direction. Lui, Strong, and Xu (1999) studied the

profitability of momentum investing in the UK market over the years, 1977­1988. They

discovered that there were significant profits associated with a momentum style of investing,

where they conclude that the majority of the momentum was the result of market under­reaction

to market news. The Dow Theory can be associated with the momentum effect. After

completing their study of the Dow Theory, Brown, Goetzmann, and Kumar (1998) concluded

that the Dow Theory was in fact a momentum strategy.

Technical Analysis

Technical analysis is “the study of market action, primarily through the use of charts, for

the purpose of forecasting future price trends (Murphy, 1986).” Although most market

participants are familiar with the study of technical analysis, very few are knowledgeable of the

Dow Theory. However, it was Dow and his creation of the theory which sparked the idea that is

presently known as technical analysis. Therefore, it is important to define and note aspects of

technical analysis not only for the sake of Dow Theory, but also to disclose the basic ideas of

technical analysis, which are discredited under the efficient market hypothesis.

Technical analysis is based upon three premises: “the markets discount everything, prices

move in trends, and history repeats itself (Murphy, 1986).” The notion that the market discounts

everything is one of the most important aspects for both technical analysis and the Dow Theory.

This statement in effect means that all information known to market traders, from company

9

fundamentals to investor psychology to political concerns will affect price movements.

Academics have studied market discounting factors such as dividends, earnings announcements,

and sentiment, all of which conclude that the market is acting as a discount mechanism. All

these items affect market movements daily through the actions of all those participating in

market trading. In fact, the idea of market discounting is one in which market efficiency and

technical analysis is in agreement. Yet, the fundamental difference is that the market is always

rational and random in the view of market efficiency. In effect, unbeknownst to most, technical

analysis does concern itself with fundamental, economic, and political factors. Indeed, it is these

factors that cause price movements in any one direction as they are the real underlying causes for

market cycles. However, technical analysts believe that if everything which affects market

“values is ultimately reflected in market price, then the study of that market price is all that is

necessary (Murphy 1986).” The technical analyst understands that there are causes for market

movements; however they do not feel it is necessary to know these reasons when forecasting

future market movements.

Along with the idea of market discounting, one must accept the idea of a trending market

to understand technical analysis. At this point, the efficient market hypothesis and technical

analysis collide in confliction. If markets are un­trending and follow a random path as described

by the random walk model then technical analysis is a useless study. However, numerous

studies have been conducted studying the existence of bull and bear markets. Lunde and

Timmermann (2003) studied the direction of stock price movement by modeling the probability

that a bull or bear market ends as a function of its age and an underlying set of variable such as

interest rates. They found that the random walk model was rejected for both bear and bull

markets, and therefore offered evidence of trending markets. Furthermore, the words bull and

10

bear markets are acknowledged among professional market traders indicating that the majority of

practitioners accept the idea of market trending cycles. Therefore, technical analysis attempts to

detect these market trends and stay with that trend until it offers evidence of reversing.

The last fundamental argument of technical analysis is that history repeats itself with the

notion that market movement has a relation to human psychology. Chartists have developed

charts and patterns which worked well in the past and tend to be successful in present day

trading. These patterns have been created with the thinking that human psychology, which tends

to be indifferent to time, will manifest itself similarly during like market conditions. For

instance, numerical barriers might be a psychological event. In the period from 1965 to 1980,

the Dow Jones Industrial Average hovered around the 1000 point barrier level, which became a

significant psychological barrier. Most recently, the Dow Jones Industrial Average drop below

10,000 was a historic price movement. These price levels also provide psychological “support

and resistance levels.” These are levels where a lower bound can offer a feeling of support and

the price level will tend to halt declines. The upper bound acts as resistance to continuing price

action, where upward price movement stops at the barrier. Additionally, reoccurring price

patterns can be described that typically act in similar manners. The most famous being the

“Head and Shoulders,” where the price pattern on a chart appears to have created a head with

two shoulders. However, a vital question still looms over technical analysis; Are psychological

emotions and investing intertwined, and is there an evident effect on market prices? The

following section examines this question and tests with regard to behavioral finance.

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Behavioral Finance

A primary explanation for inefficient markets is irrational investor behavior, which

has produced a field within itself named, behavioral finance. The study of behavioral finance is

the relation of how human emotions affect economic and investing decision making. Academics

and market practitioners are predominantly interested in the notion of irrationality and its

consequences on stock prices. Behavioral finance proposes that illogical investors skew prices

within markets and this price deviation creates opportunities for excess returns. In effect, market

alpha is the result of irrational human emotions and their ensuing effects on stock purchases.

Advocates of behavioral finance (i.e., the effects of human behavior on market prices)

claim that because humans cannot completely ignore certain emotions such as greed, pride, and

remorse when making investment decisions, it is unlikely that markets are efficient. These

supporters cite under­ and over­reactions to market news, trends in stock pricing, market herding,

and market anomalies as evidence of market inefficiency. The effects of investor emotion have

been categorized by scholars to include certain market behaviors including the loss aversion

effect, gamblers’ fallacy, mental accounting, disposition effect, money illusion effect, irrational

exuberance and the self serving bias.

One of the most predominant human emotions cited as having an impact on investor

judgment is overconfidence. Undoubtedly, people display overconfidence and psychologists

have reported overconfident behavior in numerous professions such as physicians and nurses

(Christensen­Szalanski and Bushyhead 1981), lawyers (Wagenaar and Keren 1986), investment

bankers (Staël von Holstein, Carl­Axel S. 1972), managers (Russo and Schoemaker 1992), and

many more. Overconfidence in the work place results in people overestimating their knowledge

and skills, underestimating their risk, and making them subject to a delusional feeling of control.

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Within the investment world, overconfident behavior leads to a greater number of trades as well

as misinterpretation of information (Barber and Odean 1998). High investment turnover is

disadvantageous to an investor’s portfolio. In their study of investor portfolio turnover, Barber

and Odean found that, not only is high portfolio turnover costly, it also results in higher risk and

less portfolio diversification.

The disposition effect is another widely cited example of psychological investing,

which displays the effects of investor emotion and stock purchases. The disposition effect is

described as the affinity to sell stock shares whose prices are increasing and buy shares whose

prices are decreasing. This strong impact of regret influences investors to hold losing stocks into

further losses even though it may be logical to sell. The investor is more willing to recognize

gains than to realize losses. This idea was first championed by Amos Tversky and Daniel

Kahneman (1979), in their prospect theory, also known as loss aversion theory. Tversky and

Kahneman suggest that when individuals must decide between alternatives that involve risk, they

order the decisions based upon outcomes they see as identical, and refer to it as a reference point.

Any outcome perceived to be less, is considered a loss, while any outcome seen to be above the

one reference point is considered a gain. This theory helps to explain why people are

particularly interested in gambling or insurance. In short, a person becomes more risk averse as

gains enlarge and more susceptible to loss aversion when losses enlarge. Shefrin and Statman

(1985) simplify this phenomenon by claiming that “because people dislike incurring losses much

more than they enjoy making gains, and people are willing to gamble in the domain of losses,

investors will hold onto stocks that have lost value and will be eager to sell stocks that have risen

in value.”

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Miller and Ross (1987) studied the effects of the self­serving bias on investor decision

making. Miller and Ross described the bias as a human’s tendency to quickly claim

responsibility for successes, while refuting or placing blame for failures. They continued to

reveal that these inclinations may result in investors creating a false idea that they excel in areas

closely related to their self esteem issues. This offers an explanation of under­ and over­

reactions within the market place. Miller and Ross sum up the argument, “A man’s interest gives

a bias to his judgment far oftener than it corrupts his heart…. He overestimates and keeps

constantly before his mind the strength of the arguments in favor of, and underestimates, or

never considers at all, the force of the arguments against.” Furthermore, Debondt and Thaler

(1985) published a research on overreaction in the financial market place to unanticipated

information. Their study found that people tend to overreact to unforeseen news, which then

resulted in irrational movement of stock values.

The Dow Theory as well as technical analysis maintains the view that investors are

irrational as a result of human emotions and therefore markets can become more predictable.

The Theory is described as a set of trading rules to assist the investor in decision making.

However, dependent upon the results of this research, the Theory may reveal a stock market

anomaly and provide evidence for market inefficiency. The following sections will thoroughly

describe the Dow Theory, first covering its history and then revealing its basic tenets.

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THE DOW THEORY

The Dow Theory was first developed in the early 1900s, however its laws and

principles have circulated among investors through the ages. During this time, specific students

have been influential to the development of the Dow Theory as we know it today. The great

Dow Theorist Robert Rhea once described the development of the Dow Theory as similar to that

of the automobile.

“To the automobile of 1902, our engineers later added improved motive power, demountable rims, electric lights, self starters, and other needed refinements which eventually gave us a reliable and convenient means of transportation. In a similar manner, Hamilton (among others) tested and improved the Dow Theory (….). As the record of the averages unfolded with the years, he gave us a well­defined and exceptionally reliable method of forecasting the trends of both stock prices and business activity.” (Robert Rhea, 1932)

The following is a synopsis of the Dow Theory’s movement and progression throughout

investing history.

Origins

The origin of Dow Theory dates back to the great Charles H. Dow, investor and

publisher of The Wall Street Journal. Dow began his lifelong passion with financial markets in

1885 when he started a career at the New York Stock Exchange. Upon retracing history, an

astute researcher will realize that The Dow Theory was never actually written by Charles H.

Dow himself. On the contrary, The Dow Theory was derived from editorials written on stock

speculation by Charles Dow, in his investment newspaper, The Wall Street Journal from 1900 to

1902. In 1896, Dow revolutionized the industry of stock trading by developing an idea of

clustering stocks together to measure the performance and health of the economy. These

groupings of stocks were known as stock averages and in Customers’ Afternoon Letter,

published by Dow, Jones, and Company, Dow revealed the Dow Jones Industrial Average

(DJIA) to the business world for the first time. The DJIA would contain 12 industrial stocks that

15

would most accurately reflect the performance of the economy. Soon thereafter, Dow developed

a separate average of transportation stocks. These averages would become the basis for Dow’s

Theory on stock market price changes.

Dow’s editorials described his daily observations of the average price movements in

the railroad and industrial stocks of the Dow­Jones averages. Dow never referred to his market

ideas as the Dow Theory, and despite great public demand for a written novel explaining his

market observations, Dow refused. Nevertheless, a close friend, S.A. Nelson published the first

book on The Dow Theory, titled, “The ABC of Stock Speculation,” which consisted of 15 of

Dow’s editorials. Ultimately, Nelson’s book acted as the first explanation of Dow’s market

ideas, resulting in their official recognition as the Dow Theory.

Following Dow’s death in 1902, William Peter Hamilton, a close study and

disciple of Dow’s market beliefs, assumed the position as editor of The Wall Street Journal.

During his career, Hamilton published 252 editorials appearing in The Wall Street Journal and

Barron’s between the years 1903 to 1929 in which he applied the Dow Theory to market

activity. In 1926, the second academic book written on the Dow Theory was published by

Hamilton, “The Stock Market Barometer.” Essential to the development of the Dow Theory,

Hamilton’s book offered his own rendition of the market theory to the public. As Hamilton so

closely followed the teachings of Dow, the book included much of Dow’s writings and market

philosophy. However, Hamilton’s own interpretations of Dow Theory were included as well,

with his most famous concept being the confirmation of the Industrial and Transportation

averages.

Like all market theories, doubt existed among academics with regard to the

effectiveness and legitimacy of the Dow Theory. In 1932, Alfred Cowles performed the earliest

16

test of the Dow Theory, where he studied its tenets and application as interpreted by William

Peter Hamilton over the period 1902 to 1929. By categorizing and documenting Hamilton’s

market calls, Cowles concluded that Hamilton’s returns were subordinate to market returns

resulting in a loss of credibility in the Dow Theory. However, Cowles tests were re­analyzed

and tested by Brown, Goetzmann, and Kumar (1998) by revisiting the research paper of Cowles.

They concluded that Cowles assessment of The Dow Theory via the interpretations of Hamilton

was invalid with the existence of present day knowledge regarding risk and return payoff. After

analysis of Hamilton editorials and market calls, they concluded that Hamilton’s portfolio

achieved positive risk­adjusted returns. Brown, Goetzmann, and Kumar (1998) note that, in

agreement with Cowles, Hamilton’s portfolio is frequently out of the market however, with

consideration for systematic risk, evidence supports Hamilton as a market timer.

Robert Rhea was a close student of Hamilton’s and wrote the third installment in the

series of the Dow Theory novels. His book, “The Dow Theory,” written in remembrance of the

late William Peter Hamilton, was the first of its kind as it offered the earliest outlined version of

the Dow Theory in a codified and distinguished manner, easy for investors to follow. Indeed, it

was Rhea’s goal to reduce the Dow Theory to a manual for all those wishing to use the theory as

an aid in stock speculation. After Rhea’s death in 1939, the Dow Theory lay dormant with little

recognition.

Following World War II, Dow Theory was unearthed again by E. George Schaefer.

Schaefer began his career as a stockbroker with Goodbody & Co., and like previous theorists,

spent numerous years studying the Dow Theory and the writings of the late Charles Dow.

However, Schaefer thought differently than his previous two theorists, Hamilton and Rhea, as he

was adamant on values within the stock market. Schaefer believed that Hamilton and Rhea

17

concentrated far too heavily on the technical patterns of the market and lost sight of purchasing

good values and holding them through the cycles of a bull market. Schaefer believed that a study

of the Averages would be highly rewarding, however predicting solely based upon past

movement could not be decisive evidence. According to Schaefer, reinforcing predictions with

value oriented analysis such as the 200­day moving average, the short interest ratio, the advance

and decline ratio, Dow’s 50% principle, market sentiment, market phases, and the yield cycle.

Previously, Dow Theorists disregarded these principles because they felt the principles interfered

with the basic tenets of the Dow Theory.

Basic Tenets of Dow Theory

As illustrated in the history of the Dow Theory, there has been a handful of theorists who

have contributed to the theory, with each adding his explanation for interested investors. The

following is the description of the Dow Theory as it will be tested in this paper. It is understood

that each theorist has his own interpretation of the Dow Theory. For the purposes of this thesis,

the details of each theorist’s opinions regarding the theory will not be investigated. Instead, the

basic tenets of Dow Theory, common to all Dow theorists, will be the only material considered.

1) The Averages Discount Everything

Discounting of the averages is the notion that daily price movements of the averages are

the result of all information, past, present, future, being discounted or digested by the markets.

Therefore, markets are a product of all information including economic health, media influence,

company announcements, human emotion, etc., with the exception of unforeseen “acts of God,”

such as natural disasters.

18

2) The Three Trends

Dow Theory is based upon the notion that prices move in trends. A trend is a consistent

price change which leads to a general direction of the market over a prolonged period of time.

From a chartist perspective, it is the successive rally or decline from a value which surpasses or

declines the previous value. Within Dow Theory, there are three trends identified, the primary

trend, the secondary trend and the minor trend.

i. The Primary Trend

The primary trend is the longest lasting of the three and is the major trend of the market.

Regardless of the action in secondary and minor trends, the major trend is always considered to

be in effect until a reversal of the trend is confirmed. A reversal is signaled by a confirmation of

the transports and the industrials in a given direction. These primary trends can be broken into

two categories, known as bull and bear markets.

ii. The Secondary Trend

According to the Dow Theory, every market has a primary trend or direction it moves for

a period of time lasting, typically, from one to three years, but at times, much longer. However,

among this primary trend, there are secondary trends which affect price movements of the

averages. These secondary trends move opposite to the primary trend and can be described as

price corrections. Typically, secondary trends last from three weeks to three months and are

usually more volatile than the primary trend.

iii. The Minor Trend

The third market trend recognized by the Dow Theory is the minor trend, which is a

market movement lasting less than three weeks. These trends are opposite to the movement of

the secondary trend, however they are rarely considered by Dow theorists. Minor trends are

19

thought as being too short term and irrelevant; Dow theorists typically defer to the primary and

secondary trends of the market.

6) The Phases of Primary Trends

Every market has a primary trend and it is essential for the primary trend to be closely

monitored. The primary trend is the overall long­term movement in the market, which can be

categorized as a bullish or bearish market trend. The Dow Theory breaks these bull and bear

market trends into three different phases.

i. Bull Market: Accumulation, Public Participation, & Excess Phases

A bull market primary trend can be divided into three market cycles, The Accumulation

Phase, the Public Participation Phase, and the Excess Phase. Each phase has its own

characteristics and explanations for its existence within the primary trend cycle.

The accumulation phase begins the upward trend of a bull market. It is at this moment of

the market cycle that stocks have been depressed to values attractive to informed investors. This

stage comes with the culmination of a downtrend in the market where market sentiment is at its

lowest levels. The markets have been fully dejected to lows which remain unaffected by

additional unfavorable market news. At this point, the market is considered to have discounted

all inauspicious reports and the market is poised for an accumulation by savvy investors.

The next phase of a bull market is described as the public participation phase. During

this phase, pessimistic sentiments begin to loosen and positive economic earnings and growth

begin to develop among companies. Soon thereafter, this encouraging information spreads

ensuing in increased participation from investors. This augmented public participation results in

larger buying volume and ultimately a rising or bullish market. The public participation phase is

usually the longest of all three market phases and normally has the largest price movements.

20

The final phase of an upward trending market is known as the excess phase in which the

market is now appealing to all investors, perhaps including some who have never before

invested. News regarding company earnings and growth become old news quickly and the

market is strangled by the irrational exuberance of the market players. At this point, there is no

weak buy on Wall Street and everyone wants a piece of the action. This is considered the top of

the bull market phase and is similar to that of a market bubble. The smart money begins to

reduce its market holdings and the upward movement begins to weaken. Market values are

highly overpriced at this point and all new entrants are buying at the top of the cycle. At this

moment, the market has topped and the investor should move money out of the market. It should

be noted that any great bull market falls victim to market corrections. As previously stated, these

market corrections are known as secondary trends and minor trends. However, these subordinate

trends are temporary and do not affect the overall movement of the primary trend.

Figure 1. The three stages of a Bull market

21

ii. Bear market

As most investors know, a great bull run inevitably will end with the birth of a bear

market. By definition of the Dow Theory, bear markets can also be classified according to three

market phases, the Distribution Phase, the Public Participation Phase, and the Panic Phase.

The distribution phase marks the end of the bull market’s excess phase, with the

beginning of a bearish trending market. At this time, informed investors begin to distribute their

positions in an overbought market by selling securities. This is the exact opposite of the

accumulation phase in a bull market where investors are accumulating securities at an oversold

market value. However, initially, sentiment will remain optimistic at the start of this phase, as no

one sees an end to the mighty bull of the excess phase. At this point, the market begins to slow

and is not surpassing previous highs. The market may be seen as turning flat with increased

selling pressures. Larger numbers of investors begin to see the market weaknesses and selling

continues pushing the market lower.

Similar to bull markets, a bear market is also affected by a public participation phase.

During this point, the public begins to become aware of the dwindling market and worsening

economic conditions; larger sell­offs ensue. Like the bull market phase, the bear market public

participation phase is typically the longest, resulting in the largest changes in prices of the three

phases. Large market movements are typical as selling volume is amplified amidst the continual

digestion and discounting of dire economic news.

The final stage of a bear market is described as the panic phase where investor emotions

drive price movement. At this phase, a feeling of despair and panic is controlling investing

behavior and exceedingly large sell­offs in short periods of time are widespread. Company and

country specific economic outlook continues to worsen at this point and investors continue

22

discounting the worsening condition. As the panic phase continues, nearly all investors have

sold their stakes in the stock market pushing stock values to depressed, oversold conditions.

However, these oversold conditions merely result in the beginning of the next bull primary trend

and the accumulation phase of the market cycle.

8) The Two Averages Must Confirm

The most followed aspect of the Dow Theory is the consideration for the movements of

the Dow Transports and Industrials Averages. From a Dow Theory standpoint, each average

must confirm one another’s price movements for there to be any value in predicting changes in

primary trends. A confirmation of the averages can be defined as each average either surpassing

previous highs or each breaking to new lows. Therefore, both averages must perform similarly

in order to understand the movement of the market. If non­confirmation or divergence occurs

from one or both averages, a Dow Theory warning flag is signaled and the investor should

beware. The thought process behind the confirming averages is derived from a trickle down

effect; that economic conditions affecting industrial companies should trickle down to affect

transportation firms in a similar manner. For instance, a strong economy which is powerfully

manufacturing products, should also post positive performance in its transportation industry

whose responsibility is to transport the finished goods. Therefore, the averages should move

together; if the economy is sluggish, industrial production is reduced and the transportation of

goods slows as well.

9) Volume must Confirm the Trend

Understanding the movements of the indexes is the result of studying the averages and

their movements, whether it be confirming or non­confirming. This is the foremost tool used in

Dow Theory. However, following changes in volume is used as a secondary indicator in

23

predicting market price changes and trend directions. Dow Theory presumes that volume should

increase when price moves in the same direction of the trend. Conversely, volume should

decrease when price moves opposite to the existing market trend. The logic is explained as

volume should increase with movements in price that are in accord with the trend because

investors continue buying/selling the trend. The increasing volume reveals investor confidence

in the continuance of the existing trend. However, if weak volume accompanies the market

trend, it is a sign that investors are less willing to participate in the opposite direction of the

market, thus signaling a change in the trend. On the contrary, a volume­confirming trend reveals

to investors that the popular opinion of the market is in agreement with the trend.

10) Lines

Lines are described as the horizontal trading range in the averages where there is an equal

pressure of buying and selling. The index appears to be locked between an upward and

horizontal range, where it is typically seen as a period of consolidation. However, an upward

break of the trading line, with the line then becoming a support, is considered a bullish move.

The opposite is true for a bearish breakage of the pattern where the lower bounds of the line is

broken and then becomes a resistance. This market will be likely to trend down.

11) Only Closing Prices Used

Charles Dow concerned himself only with closing prices and therefore neglected intraday

price movements in the index. Consequently, Dow Theory signals are only valid if price

changes hold until the end of the trading day. It is then important to understand that Dow Theory

signals can be seen on an intraday basis; however these intraday Dow Theory signals may finish

the day unrecognizable by Dow Theorists if the price ends otherwise.

24

12) Trend Assumed to Continue until Reversal signaled

Dow Theorists trade on what they believe to be the primary trend. Therefore, it is

important to know the direction of the primary trend, and also know when the trend has reversed.

Reversals in the trend are accompanied by Dow Theory buy and sell signals. These signals can

be characterized by movements of the Industrials and Transportation averages. The joint

direction and subsequent surpassing or violation of market highs or lows, will determine the

trend of the market. However, the trend remains in force until proven otherwise by a reversal.

13) Values

The Dow Theory is a compilation of many ideas from numerous theorists throughout the

years. Therefore, the central focus of each theorist’s attention to the theory has been slightly

different through the years. Although the Dow Theory has been most popularized by the

movement of the Index averages, Charles Dow concerned himself mostly with values. Dow

recognized that the indexes moved in cycles which could be categorized as periods of

overvaluation and undervaluation. To measure the extent to which prices were under­ or over­

valued, Dow used the average dividend yield of the stocks in the indexes. Historically, the

beginning of a bear market began with end of a bull market with an average dividend yield of

2­%­3%. Bull markets began when dividend yield on the index reached a level of 6%­7%. This

historically phenomenon can be documented up until the early 1980s. However, since then,

dividend yields have continued to decrease to levels well below the known values associated

with bull market tops.

14) Criticisms

A major criticism of the Dow Theory is that it fails to capture all of the market

movement. On average, the theory misses 20%­25% of a price movement before generating a

25

signal (Murphy 1986). Typically a Dow Theory buy or sell signal is triggered after the

completion the first phase of the market cycle. For many traders, this is too late, as the Dow

Theory misses a large portion of the price movements and potential profits or losses. However,

the theory performs just as Charles Dow had anticipated. Charles Dow sought to recognize the

materialization of new bull and bear markets and capture the large portion of price movements of

the cycle.

A HISTORICAL COMPARISON OF THE AVERAGES

A stock average can be described as a group of specific companies molded into one price

movement in an attempt to monitor the over all health of a sector. It has been over 100 years

since the creation of “averages” therefore clearly the components of these averages have changed

over time. Dow theorists closely follow the price action of the Dow Jones Industrial Average

and the Dow Jones Transportation Average. The following will outline how and why these

averages are created as well as offer a brief history of their components.

Dow Jones Industrial Average (DJIA)

The Dow Jones Industrial Average was created by Charles H. Dow in 1896. Dow’s

motivation to create the average was to measure the overall performance of the industrial sector.

Thus, the DJIA consisted of the top industrial companies of the time. However, today, the

average more accurately represents the overall health of United States economy and generally

sets the overall trend of the market. Companies are added or removed as determined by Dow

Jones & Co., in an attempt to best represent the US economy.

26

Table 1. Comparison of DJIA Components. This table lists the companies in the DJIA for the years 1896 and 2008.

Components (1896) 1 Components (2008)

American Cotton Oil 3M General Electric Pfizer American Sugar Alcoa General Motors Procter & Gamble American Tobacco American Express Hewlett­Packard United Technologies Corporation

Chicago Gas AT&T Home Depot Verizon Communications

Distilling and Cattle Feeding Bank of America Intel Walmart

General Electric Boeing IBM Walt Disney

Laclede Gas Caterpillar Johnson & Johnson

National Lead Chevron Corporation JPMorgan Chase

Tennessee Coal & Iron Citigroup Kraft Foods

North American Coca­Cola McDonald's

U.S. Leather (preferred) DuPont Merck

U.S. Rubber ExxonMobil Microsoft

Dow Jones Transportation Average (DJTA)

The Dow Jones Transportation Average was created to follow the health of the United

States transportation sector. Therefore, the components, or companies, were chosen in a manner

that most accurately reflects the transportation sector in the United States. Of course, the

transportation industry has changed through time, which consequently resulted in modifications

to the DJTA. When the DJTA was created, the primary form of shipping was by means of

railroad. This explains why the DJTA in 1900 consisted of nine railroad companies and two sea

freight corporations. Today, the DJTA has nine additional components, totaling twenty

companies. At present, there are four trucking, four railroad, four major and regional airlines,

four air delivery and freight services, two rental and leasing, and two shipping components.

1 DJIA was created May 26, 1896 by Charles H. Dow

27

Table 2. Comparison of DJTA Components. This table lists the companies in the DJTA for the years 1900 and 2008.

DJTA Components (1884) 2 DJTA Components (2008) New York Central (railroads) Alexander & Baldwin, Inc. (ALEX) (shipping) Chicago Milwaukee & St Paul (railroads) AMR Corporation (AMR) (major airlines) Chicago & North Western (railroads) Burlington Northern Santa Fe Corp. (BNI) (railroads) Delaware Lackawanna & Western (railroads)

C.H. Robinson Worldwide, Inc. (CHRW) (air delivery & freight services)

Lake Shore (railroads) Con­Way, Inc. (CNW) (trucking) Louisville & Nashville (railroads) Continental Airlines, Inc. (CAL) (major airlines) Missouri Pacific (railroads) CSX Corp. (CSX) (railroads) Northern Pacific (railroads) Expeditors International (EXPD) (air delivery & freight services) Union Pacific (railroads) FedEx Corporation (FDX) (air delivery & freight services) Pacific Mail Steamship (sea freight) GATX Corp. (GMT) (rental & leasing services) Western Union (sea freight) JB Hunt Transport Services, Inc. (JBHT)(trucking)

JetBlue Airways Corp. (JBLU) (regional airlines) Landstar System, Inc. (LSTR) (trucking) Norfolk Southern Corp. (NSC) (railroads) Overseas Shipholding Group, Inc. (OSG) (shipping) Ryder System, Inc. (R) (rental & leasing services) Southwest Airlines, Inc. (LUV) (regional airlines) Union Pacific Corp. (UNP) (railroads) United Parcel Service, Inc. (UPS) (air delivery & freight services) YRC Worldwide Inc. (YRCW) (trucking)

Ten years of the Dow Theory

During most of the 1990s, the Dow Theory signaled a bullish market. However, on

September 23, 1999, the DJIA broke below its May low of 10,466.93, thereby confirming the

DJTA violation below its June lows of 3,316.11 on August 4 th , 1999. This dual violation of lows

signaled that a primary bear market was in force, and all equity positions should be liquidated.

Cash was the ideal investment position. Approximately six months later, on April 4, 2000 the

Nasdaq crashed with losses seen in all averages. The Dow Theory continued to be bearish for

the next six years. During this period, dividend yields and Dow Price/Earnings ratios hit record

levels. According to Dow’s value thesis, returns in the equity market were unattractive and

2 DJTA was created July 3, 1884 by Charles H. Dow.

28

value should be sought elsewhere. On April 25 th 2007, with both averages reaching their all­time

highs, a bullish signal to be long the market was given. However, Dow theorists were long the

market for only five months until the markets began to deteriorate under the tenets of Dow

Theory. By the end of November, the DJIA confirmed the already weak DJTA by breaking its

August 19 th , 2007 low of 11,348.55. After the confirmation by the DJIA in 2007, the Dow

Theory continued to signal bearishness in the market. The recent price action in the third quarter

of 2008 has been particularly bearish. The primary bear market was reconfirmed when the joint

violation of lows was recorded; the 11,348.55 low was violated by the DJIA and the 4,384.36

low of the DJTA. According to the Dow Theory, the primary trend of the market is bearish and

investors should be out of the market and in cash.

Presently, the DJIA is nearing two critical levels; Dow’s 50% level, which is half the bull

market rise of 1982­2007 and the DJIA low of 2002. The DJIA low of 2002 is 7,286 and the

50% principle level is 7470. If the DJIA violates the critical value of 7470, a critical support

level, then most of the rise from 1980 will be erased. Furthermore, if Dow’s value thesis is

correct, the bear market lows will be seen when dividend yields reach 6%. For this to occur, the

DJIA must fall into the 5,000s.

29

Figure 2. DJIA 10 Year Price Movement. This figure shows the price movement of the Dow Jones Industrial Average over the last ten years. Green arrows mark Dow Theory signals.

30

Figure 3. DJTA 10 Price Movement. This figure shows the price movements of the Dow Jones Transportation Average over the last ten years. Red arrows mark Dow Theory signals.

RICHARD RUSSELL: A REVIEW

Richard Russell has continually published Dow Theory Letters since 1958, and he has

been writing the Letters ever since allowing him the designation as the oldest advisory service

continuously written by a single person in the business. The Letters are published every three

weeks at a cost of $300 per year and cover the US stock market, foreign markets, bonds, precious

metals, commodities, economics, and stock market observations and philosophy. Russell is

considered to be the chief scholar on Dow Theory today as he has over 12,000 subscribers to

Dow Theory Letters, from all 50 states and many foreign countries. Russell has written

numerous articles and he has been quoted in such publications as Bloomberg Markets, Barron's,

Time, Newsweek, Money, The Wall Street Journal, the New York Times, Reuters, and others

where he applied Dow Theory principles in his market analysis. Although much of his

31

popularity has come from beginning the Dow Theory Letters, Russell also gained

acknowledgment from a series of over 30 Dow Theory and technical articles that he wrote for

Barron's during the late 1950s through the 1990s. Through his interpretations of the Dow

Theory, Richard Russell has called the top of the 1949­1966 bull market. Also, he called the

bottom of the great 1972­1974 bear market almost to the day, as well as the beginning of the

great bull market which started in December 1974.

Technical Indicators: Russell’s Top Five

The chief concern of this thesis is to test the Dow Theory; however it is important to

remind the reader that this is a test of the Dow Theory as interpreted by Richard Russell.

Technical indicators aside from the Dow Theory accompany Russell’s market analysis and he

uses these indicators in an attempt to more completely understand and digest the price

movements in financial markets. However, above all, Russell always acquiesces to the

movement of the averages and the primary trend of the market according to Dow Theory signals.

Nevertheless, it is important to define the technical indicators he employs.

1) As one might infer, Russell’s number one indicator of market movement is the

combined movement of the Dow Jones Industrial Average and the Dow Jones Transportation

Average. Above all, Russell follows these movements to understand the primary trend of the

market. When bull or bear market signals are indicated by the averages, no other indicator is

superior.

2) Russell’s second most valued indicator is in fact one he created himself in 1969, which

he calls the Primary Trend Index, or more simply put, the PTI. The PTI consists of eight “action

32

of the market” indictors which serve to clarify the primary trend of the market. Therefore, the

PTI is classified as being bullish or bearish, dependent upon its action above or below its 89­day

Moving Average. The names of the indicators used in the creation of the PTI and its true

construction are unknown to the public.

3) Russell is an advocate of the Advance/Decline (AD) used in unison with other

technical indicators. The AD ratio is also known as the market breadth, as it reveals whether

large moves in the market are the result of numerous stocks, or merely a handful. Russell uses

the AD ratio to define “buying stampedes,” a period when there is massive injections of capital

into the market. It is an indication of the larger institutions entering the market and offers

validity of the market trend. A buying stampede is defined as a time period where several weeks

of steady rises in the AD ratio amounts to a five­point appreciation of the AD ratio. Russell

follows the AD ratio with the movement of the averages to understand the trend of the market.

4) Dow’s 50% principle is always considered by Richard Russell. The 50% principle

asserts that the 50% level of the total rise of a bull market should act as very strong support for

an ensuing downfall. However, if this 50% level is broken, it is an ominous omen of the

upcoming bear market. The principle is in effect during primary bear markets as well. If prices

are unable to recoup more than 50% of the previous price depreciation, it is assumed that the

negative trend remains in effect until otherwise proven different.

5) Russell is also a firm believer of Dow’s value thesis. Charles Dow advocated buying

stocks at great values or at the bottom of a bear market where stock prices were at attractive

levels. To identify these market bottoms and tops, Dow used the average dividend yield of the

Dow Jones Industrial Average. The dividend yield on the market was preferred for its inability

33

to be “cooked up” by business executives. It is a true number, which reflects the overall

corporate dividend payments to shareholders. Stock prices and the dividend yield are inversely

related, meaning that as stock prices rise, dividend yields decrease. Therefore, as stock prices

rise to levels of overvaluation, the dividend yield reduces to extreme levels. Average dividend

yields associated with bear market lows are usually 6%­7%. Average dividend yields

historically reported at bull market highs are in the 2%­3% range.

METHODOLOGY

Two tests will be performed in an attempt to analyze the success of the Dow Theory by

way of Richard Russell’s interpretations. Beginning in the year 1975, all of Richard Russell’s

editorials will be classified as being either bullish or bearish. These classified editorials will be

used to conduct two tests, which will include a modeled portfolio and an event study. It is

imperative to articulate that this test of the Dow Theory is only considering US equities from

1975­2008. Although, Richard Russell’s investment news letter advises clients to pursue other

investment classes aside from equities, such as gold, bonds, foreign equities, currencies, and

mutual fund/exchange traded funds, they will not be considered in this analysis. It can then be

established that this is not an exact replication of Richard Russell’s portfolio return during the

period tested. The following paragraphs will offer an explanation of each test as well as a

thorough description of its uses in this research.

Dow Theory Event Study

An event study methodology will be incorporated in the analysis of the Dow Theory.

After the categorization of the editorials and the documentation of the market calls by Richard

Russell, the action of the Dow Jones Industrial Index will be followed. The objective is to

34

document whether positive market action is followed by bull calls and negative market

movement occurs after bear calls. Each market call will be treated as an individual event and the

results of each event will be displayed as an equally weighted average. The event will be

characterized as the market action of the Dow during the period forty days prior to the market

call to forty days following the call. As an example, assume Russell’s market call was bullish

and the Dow recorded positive price change during that period. This would be in favor of the

predictive powers of the Dow Theory. The final average of all the event studies will allow a

model which develops a cumulative single outcome of the editorials.

Hypothetical Portfolio: measuring Dow Theory vs. the S&P 500

In an attempt to gain true insight of the overall performance of the Dow Theory, a

simulated portfolio will be created with an investing horizon during the considered editorials

between the years 1975­2008. This test not only allows us to see the overall performance of the

Dow Theory versus a broad market index such as the S&P, but in addition, provides us with

relative calculations such as comparative returns and portfolio risks. The hypothesized portfolio

allocations will vary according to the market calls derived from the tenets of the Dow Theory

and Richard Russell. Given that the objective is to test the Dow Theory’s usefulness in market

timing, the portfolio will be long the S&P 500 when a bullish Dow Theory signal is indicated

and long the prevailing 1­Year Treasury Constant Maturity Rate for a bear signal. The portfolio

will be compared to a buy and hold strategy of the overall market return of the S&P 500 for the

past 33 years. Since the Dow Theory does not provide an exact matrix for picking individual

stocks, the S&P 500 will be used as our broad market index. The portfolio will be re­balanced

on the day subsequent to the market call as provided by the Dow Theory Letters.

35

RESULTS

Event Study

The average 81­day market movement for editorials classified as being bullish was 2.9%.

Conversely, during periods where Russell was bearish, the average 81­day market movement for

bearish editorials was 2.25%. The results conclude that bullish market movement followed

bullish editorials. However, and on average, bearish market movement was not witnessed after

bearish editorials. It is difficult to say whether these are accurate reflections of the

successfulness of Russell’s market calls. At the very least, however, these results indicate the

conservative style of investing employed by Russell. Because the S&P 500 actually appreciated

during periods when times Russell was bearish, it can be inferred that he was protecting his

wealth during what appeared to be uncertain times. Written by Richard on multiple occasions,

he describes his way of investing. He states that the goal should be to appreciate wealth without

taking the “big loss.” The fear or avoidance of taking the big loss may have caused Russell to be

out of the market during bullish market movements. Nonetheless, it can be ascertained from the

data that Russell was more successful in forecasting bullish times than bearish times.

Hypothetical Portfolio:

A hypothetical portfolio was created as a metric for comparison against the S&P 500

“buy and hold” strategy. Transaction costs and taxes were excluded in the calculation values of

both portfolios. The S&P 500 is a very common benchmark to be used when analyzing portfolio

performance, thus it makes for a perfect comparison to the hypothetical portfolio, called “Dow

Theory Portfolio.” Figure 2 and Figure 3 shows the annual geometric return of the Dow Theory

Portfolio versus the Buy and Hold Portfolio for the entire holding period of 33 years from 1975

36

to present day, 2008. It is apparent that the Dow Theory Portfolio is a less volatile portfolio than

the buy and hold strategy. In fact, during the 33 year trading period, the Dow Theory Portfolio

had only six years of negative returns which can be summed up to ­9.78% of cumulative losses

compared to the buy and hold strategy which dipped into negative territory a total of seven times

with an accumulative loss of 86.26%. 3

Figure 4. Annual Portfolio Return Comparison. This figure graphically shows the change in return for each portfolio from 1975 to 1992.

Annual Geometric Return (1993­2008)

­40.00%

­30.00%

­20.00%

­10.00%

0.00%

10.00%

20.00%

30.00%

40.00%

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Year

Ann

ual R

eturn

Dow Theory S&P 500 Buy and Hold

3 For a complete table annual return comparisons, see table 1 in the appendix section.

37

Figure 5. Annual Portfolio Return Comparison. This figure graphically shows the change in return for each portfolio from 1993 to 2008.

Annual Geometric Return (1975­1992)

­15.00%

­10.00%

­5.00%

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

35.00%

40.00%

1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992

Year

Ann

ual R

eturn

Dow Theory S&P 500 Buy and Hold

On the basis of total accumulated return, the Dow Theory Portfolio was unable to

outperform the S&P 500 buy and hold strategy. The Dow Theory Portfolio had a geometric

annual return, including a dividend yield approximation, of 10.21% where as the Buy and Hold

Portfolio had a geometric annual return including dividend yield approximation, of 11.28%. The

annualized standard deviation of the Dow Theory Portfolio was 10.6% versus an annualized

16.25% standard deviation for the Buy and Hold Portfolio. To gain a full perspective of the risk

associated with both portfolios, the Sharpe Ratio was calculated. On a risk­adjusted basis, the

Dow Theory portfolio was a more attractive investment. The Dow Theory portfolio reported a

Sharpe Ratio of 0.37 versus a 0.31 for the S&P 500 Buy and Hold portfolio. 4 An additional

4 Sharpe Ratio:

38

indicator of lower risk for the Dow Theory Portfolio was its beta calculation of 0.88 with respect

to the S&P. 5

Table 3. Summary of Portfolio Comparison Metrics. This table reports common calculations used to compare portfolio returns.

Dow Theory Portfolio Buy and Hold Portfolio Mean 10.17% 12.02%

Minimum ­8.06% ­32.07% Maximum 33.27% 36.47%

Standard Deviation 10.60% 16.25% Beta 0.88 1.00

Annualized Return 10.21% 11.28% Sharpe Ratio 0.37 0.31

Jensen's Alpha 6 ­0.47% ­

The two strategies produced similar results from 1975 through 1988 with the Dow

Theory Portfolio surpassing the S&P 500 Buy and Hold Portfolio in aggregate return during the

year of 1987. The dominance was brief, as the Dow Theory lagged the buy and hold strategy

thereafter until present day. Beginning with a hypothetical investment of $100,000 in each

portfolio in 1975, today the Dow Theory Portfolio is worth $2,357,809.97 versus the Buy and

Hold Portfolio value of $3,225,002.82 at the end of the investment horizon in 2008. 7

5 Beta Calculation is located in the appendix.

6 Jensen Alpha:

7 Full a complete table of dollar appreciation comparison, see table 2 in the appendix section.

39

Figure 6. Dollar Return Comparison. This figure shows the total dollar return comparison of the Dow Theory Portfolio and the Buy and Hold Portfolio from 1975 to 2008.

Aggregate Dollar Return: 1975­2008

$0.00

$500,000.00

$1,000,000.00

$1,500,000.00

$2,000,000.00

$2,500,000.00

$3,000,000.00

$3,500,000.00

$4,000,000.00

$4,500,000.00

$5,000,000.00

1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007

Year

Portfolio

Value

S&P500 Dow Theory Portfolio

After 1987, the Buy and Hold portfolio begins a steep appreciation above the Dow Theory

portfolio. A central cause for this large differentiation is that the Dow Theory portfolio was out

of the market 63% of the time from 1987 to 2008. The main reason for the bearishness of the

Dow Theory portfolio was the result of low dividend yields. According to the value thesis under

Dow Theory, historically, bull market tops were associated market dividend yields of 2%­3%.

During this time period, dividend yields reached all time lows with the Dow yielding a mere

1.17% in 1999. Even today dividend yields are still recognized as being historically below

average. However, despite these low yields, the markets continued to appreciate to

40

unrecognizable territories. It is during this time period the Buy and Hold portfolio substantially

surpasses the Dow Theory portfolio.

CONCLUSION

There is no denying that the Dow Theory portfolio was outperformed by the S&P 500

Buy and Hold strategy. However, when considering risk­adjustment metrics, the Dow Theory

portfolio fares as a formidable opponent to the ever­so­difficult S&P benchmark. In fact, the

average managed mutual fund returns 2% less to their shareholders on an annual basis than

actual S&P 500 index returns. 8 On a historic annual basis, the Dow Theory portfolio was only

1.07% less than the S&P benchmark. Furthermore, the Dow Theory was a less volatile portfolio

with a mere ­9.78% of cumulative losses compared to ­86.26% on the S&P 500 Buy and Hold

strategy over the 33 year period.

Additionally, one cannot reject the power of the Dow Theory when considering its ability

to forecast the market during critical times. The Dow Theory signaled the bottom of the 1974

market, the Dow Theory portfolio was out before the October 1987 crash, the 2000 market crash,

and recently, the Theory signaled to be out of the market before the most recent financial crisis.

Richard Russell is a proponent of appreciating capital, and preaches that, as an investor, you

“can’t take the big loss, which can wipe you clean of your hard earned capital.” Was the Dow

Theory a success in capturing sufficient alpha in the market? Not exactly, but it has proven to be

a good strategy to appreciate capital over a long­time span while avoiding major market

collapses.

8 http://www.fool.com/School/MutualFunds/Performance/Record.htm

41

It will be most interesting to see where the S&P 500 goes from here. This is considered

to be one the most crucial times during the history of financial markets. Currently, the Dow is

nearing the 50% level of the previous bull market run. Will the Dow break this critical value and

will the market spiral down as predicted by Dow Theory? More importantly, is the value thesis

still an operable indicator? If so, will this bear market end when dividend yields reach historical

values? Finally, as of today, the Dow Theory portfolio is currently beaten by the S&P

benchmark. However, where will the benchmark portfolio be two years from now? From a Dow

Theory standpoint, the greatest bull market of all time began in 1982 and most recently finished

in 2007. Consequently, this bear market should be severe, and it would be most interesting to

continue portfolio return calculations into the future. Nevertheless, when considering the

evidence gathered in this thesis, the Dow Theory is undeniably a useful tool to be incorporated in

any analyst’s market analysis.

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APPENDIX

Annual Return Comparison. All those values highlighted blue represent the portfolio with the greater return for that year.

Year Dow Theory Return S&P 500 Return

1975 18.01% 18.01% 1976 22.15% 22.15% 1977 ­8.58% ­6.01% 1978 7.45% 7.83% 1979 8.69% 17.12% 1980 20.90% 33.11% 1981 5.06% ­4.54% 1982 15.48% 19.51% 1983 23.54% 23.54% 1984 ­0.09% 6.63% 1985 31.64% 31.64% 1986 18.92% 18.92% 1987 32.83% 3.97% 1988 7.65% 12.19% 1989 6.36% 31.68% 1990 ­0.44% ­4.45% 1991 15.64% 30.88% 1992 4.28% 7.32% 1993 2.84% 9.86% 1994 ­0.05% 1.58% 1995 19.55% 36.46% 1996 21.34% 21.34% 1997 33.27% 33.27% 1998 12.64% 27.39% 1999 ­0.04% 20.78% 2000 5.48% ­8.04% 2001 5.36% ­9.16% 2002 2.29% ­21.97% 2003 1.57% 23.93% 2004 4.53% 10.93% 2005 2.68% 5.63% 2006 4.63% 13.55% 2007 ­0.54% 5.54% 2008 2.61% ­32.07%

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Dollar Appreciation Comparison. This table follows the dollar appreciation of each portfolio over the 33 years of investing.

Year Dow Theory $

Return S&P $ Return 1975 $118,012.54 $118,012.54 1976 $144,149.75 $144,149.75 1977 $131,776.69 $135,484.19 1978 $141,594.04 $146,093.75 1979 $153,905.28 $171,103.47 1980 $186,066.70 $227,749.18 1981 $195,485.44 $217,399.30 1982 $225,747.23 $259,821.89 1983 $278,889.84 $320,985.94 1984 $278,635.62 $342,269.70 1985 $366,801.46 $450,570.63 1986 $436,217.30 $535,839.48 1987 $579,423.03 $557,088.89 1988 $623,750.60 $624,996.95 1989 $663,393.32 $823,023.42 1990 $660,484.48 $786,372.82 1991 $763,772.26 $1,029,168.21 1992 $796,427.58 $1,104,520.86 1993 $819,012.31 $1,213,385.69 1994 $818,584.98 $1,232,610.24 1995 $978,623.73 $1,681,987.78 1996 $1,187,498.12 $2,040,986.00 1997 $1,582,593.14 $2,720,046.78 1998 $1,782,635.21 $3,465,059.43 1999 $1,781,863.20 $4,184,960.97 2000 $1,879,526.69 $3,848,371.90 2001 $1,980,181.86 $3,495,676.09 2002 $2,025,465.13 $2,727,559.38 2003 $2,057,259.82 $3,380,247.85 2004 $2,150,458.21 $3,749,766.31 2005 $2,208,094.52 $3,961,034.53 2006 $2,310,366.99 $4,497,865.10 2007 $2,297,877.09 $4,747,218.60 2008 $2,357,809.97 $3,225,002.82

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This table reports the annual Sharpe ratio comparisons between the Dow Theory portfolio and the S&P Buy and Hold. Column III rates the Dow Theory portfolio versus the Buy and Hold on a year end basis with “underperform” or an “over perform” based solely on the Sharpe ratio calculation.

Year S&P Sharpe

Dow Theory Sharpe

Performance vs. S&P 500

1975 0.69 1.06 Over perform 1976 1.00 1.53 Over perform 1977 ­0.74 ­1.38 Underperform 1978 ­0.03 ­0.08 Underperform 1979 0.40 ­0.18 Underperform 1980 1.30 0.84 Underperform 1981 ­1.19 ­0.92 Over perform 1982 0.45 0.30 Underperform 1983 0.86 1.32 Over perform 1984 ­0.21 ­0.96 Underperform 1985 1.43 2.19 Over perform 1986 0.77 1.18 Over perform 1987 ­0.17 2.46 Over perform 1988 0.28 0.00 Underperform 1989 1.42 ­0.21 Underperform 1990 ­0.76 ­1.16 Underperform 1991 1.54 0.92 Underperform 1992 0.21 0.04 Underperform 1993 0.40 ­0.06 Underperform 1994 ­0.23 ­0.51 Underperform 1995 1.88 1.28 Underperform 1996 0.97 1.49 Over perform 1997 1.70 2.61 Over perform 1998 1.37 0.72 Underperform 1999 0.97 ­0.48 Underperform 2000 ­0.87 ­0.06 Over perform 2001 ­0.78 0.18 Over perform 2002 ­1.48 0.03 Over perform 2003 1.40 0.03 Underperform 2004 0.56 0.25 Underperform 2005 0.13 ­0.08 Underperform 2006 0.54 ­0.01 Over perform 2007 0.07 ­0.46 Underperform 2008 ­2.10 0.06 Over perform

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Beta Calculation: This figure graphically demonstrates how the beta calculation was performed. Annual returns of the Dow Theory portfolio versus the S&P 500 annual returns were used in the construction of the beta calculation.

Beta Calculation & Characteristic Line

y = 0.88x + 0.0302

­40.00%

­30.00%

­20.00%

­10.00%

0.00%

10.00%

20.00%

30.00%

40.00%

­20.00% ­10.00% 0.00% 10.00% 20.00% 30.00% 40.00%

Portfolio Return

S&P Return

Returns Linear (Returns)