The Dow Theory
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Transcript of The Dow Theory
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Yale School of Management
The Dow TheoryWilliam Peter Hamilton’s Track
Record Re-Considered
Stephen J. Brown (NYU Stern School)
William N. Goetzmann (Yale School of Management)
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Yale School of Management
Background on the Dow Theory
Charles Henry Dow Dow indices developed for timing studies
William Peter Hamilton Editorialist applied “Dow Theory” 1902-1929
Principles market follows trends Industrial and transportation sectors confirm high volume indicates move
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Yale School of Management
Testing the Theory
Alfred Cowles III “Can Stock Market Forecasters Forecast?” E’trica 1934 Coded editorials “Bull” “Bear” or “Neutral” “Bull” = all stocks “Bear” = short stocks “Neut” = t-bills
Dow Portfolio, 1902 - 1929 vs. 100% stocks Dow: 12% return per year 1/2 DJIA & 1/2 DJTA: 15.5% return per year
Conclusion: no timing skill!
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Yale School of Management
Testing the Theory II
Bull & bear forecasts Sorted the 90 times Hamilton changed his forecast Half proved profitable, half did not
Conclusion: no timing skill!
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Yale School of Management
Problems in Cowles Analysis
100% stocks a correct benchmark? “Hamilton was long of stocks 55%, short of
stocks 16% and out of the market 29% out of the 26 years under review.”
He made 255 forecasts, not 90 Are two successive bear calls informative?
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Yale School of Management
Revisiting Hamilton’s Calls
Re-coding 46% bull calls 16% bear calls 38% neutral calls
Created contingency table call vs. capital appreciation return of DJIA until
next editorial
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Yale School of Management
The Dow Theory 1903 to 1929
BullMarket
BearMarket
BullForecast 74 56
BearForecast 18 36
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Yale School of Management
Trading Strategy Considered
Back-test of Hamilton portfolio Assume investment in S&P with dividends &
commercial paper as riskless asset. S&P index created by Cowles as capital
weighted measure of stock investment. Monthly re-balancing
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Yale School of Management
Hamilton’s Portfolio Vs. S&P
Year1903 1905 1907 1909 1911 1913 1915 1917 1919 1921 1923 1925 1927 1929
0
5
10
15
20Figure 1: Dow Theory vs. 100% Stocks
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Yale School of Management
100% S&P vs. Hamilton
100% S&P Hamilton
Strategy Return 10.75% 10.73%
Strategy STD. 12.83% 10.44%
Jensen's 0.00% 4.04%
Sharpe Ratio 45.61 % 55.89%
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Yale School of Management
Event Study
What happened to the DJIA after a call? Line up returns in event-time average across call of same direction
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Yale School of Management
Bull vs. Bear Calls
0.96
0.97
0.98
0.99
1
1.01
1.02
1.03
1.04
1.05
1.06
Pric
e In
dex
-40 -35 -30 -25 -20 -15 -10 -5 0 5 10 15 20 25 30 35 40 Days Around Editorial
buys neutrals sells
DJIA Around Editorials
Sells
Neutral
Buys
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Yale School of Management
Recovering The Dow Theory
Hamilton’s calls contain the essence of the Dow Theory.
Can we create a model of the theory?Does it correspond to the writings about it?
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Yale School of Management
Predicting Hamilton’s Signals
Use information available on the editorial date (and to us now)
See if we can forecast Hamilton’s signalsPerform out-of-sample test to see if our
recovered Dow Theory worked.
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Yale School of Management
Methodology
Step-wise regression A linear model of Hamilton “bear” signal Use AIC-like criterion to add and prune
variablesNeural network
A non-linear model of Hamilton’s signals Uses a broad range of variable transformations No “coefficients” reported
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Yale School of Management
Stepwise Regression
Intercept -1.7 60Day Ind:30Day Ind -93.8
Ind 60 Day Ret -14.2 30Day Ind:30Day Tran 64.4
Tran 60 Day Ret -9.7 60Day Tran:30Day Tran -235.8
Ind 30 Day Ret -3.7 60Day Ind:30Day Tran 100.7
Tran 30 Day Ret 6.1 60Day Tran:30Day Ind 110.3
Ind same sign Tran 0.1 60Day Tran:30Day Ind:30Day Tran
-931.3
60 Day Ind: SameSign
12.2 60Day Ind:30Day Ind:30Day Tran
345.7
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Yale School of Management
Neural Network Approach
Feature Vector Analysis A. Kumar and V.E. McGee “FEVA: Feature
vector analysis: explicitly looking for structure and forecastability in time series data,” Economics and Financial Computing, Winter, 1996
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Yale School of Management
Neural Net Events 1902-1929
0.94
0.96
0.98
1
1.02
1.04
1.06
-30 -25 -20 -15 -10 -5 0 5 10 15 20 25 30
BUYSELLNEUTRAL
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Yale School of Management
Neural Net Events 1930-1996
0.940.950.960.970.980.99
11.011.021.03
-30 -25 -20 -15 -10 -5 0 5 10 15 20 25 30
BUYSELLNEUTRAL
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Yale School of Management
Conclusions
The Dow Theory reputation was deservedHamilton followed a momentum strategyThe spread between bull and bear calls has
continued out of sample, albeit diminished