Saturday, September 15, 2012

Plain vanilla Dow Theory? Or does Dow Theory come in many flavors?

Part I. From Charles Dow to Richard Russell

Before this blog continues growing, I feel a clarification is in order.

I constantly allude to the Dow Theory as if it were a given. However, in the last 110 years substantially different investment and even trading styles have been advocated under the label “Dow Theory”. Is there a canon according whereto orthodox Dow Theory can be defined? Are the different interpretations of the Dow Theory worth bearing its venerable name?

As investors it is important to know the true implications of the Dow Theory. Are we going to invest for the long pull, for ever, or are we just traders? I always insist on “knowing your time frame”. Your profit targets (namely the “reward” side of the equation), your stops (namely the “risk” side of the equation) and your holding period all depend on the Dow Theory “flavor” you use.

Therefore, it is important to ask whether there is a plain vanilla Dow Theory or it comes in many flavors.

The answer is elusive.

To begin with, the “founder” of the Dow Theory, Charles Dow, never attempted to formulate a systematized theory as such, much less something bearing his own name. He died without having written a book. Only his editorials are a testimony of his wisdom and market acumen (which are a must read for any serious Dow Theorist, whatever the “flavor”).

Dow’s friend, a man called Nelson, attempted to gather Dow’s more important thoughts in a book. That book was published in 1902 and is called “The ABC of Stock speculation”. Please note, that the book was not entitled “Dow Theory”. The book is an interesting recollection of Dow’s thoughts and, even though profound and useful for the successful investor, it bears no resemblance to a well organized theory.

Dow’s successor at the helm of the Wall Street Journal, Hamilton, was the first practitioner that labeled Dow’s insights as the “Dow Theory”. Hamilton distilled some of the principles of Dow Theory in his famous Wall Street Journal editorials. He greatly signaled the onset of the devastating 1929-1932 bear market. He wrote a good book called “The Stock Market Barometer” which, even though containing some of the tenets of the Dow Theory was far from a fully systematized body of rules.

The Dow Theory came of age when Rhea took the lead in the ninety thirties. Robert Rhea undertook the monumental task of systematizing the whole body of work of Dow and Hamilton. He distilled it into a workable framework of theorems and rules. We can say that the “Version 1.0” of the Dow Theory as we now it know was due to Rhea. Rhea, who had survived the Great Depression thanks to his application of the Dow Theory, was very aware of the risks of being caught wrong footed when a huge bear market sets in. Perhaps because of his personal experience, his Dow Theory “flavor” favored more the “technical” side of the Dow Theory rather than the more "fundamental" one that stresses values. We shouldn’t forget that value investors were gravely fooled by the 1929-1932 bear market. Each compelling value was followed by a new vicious decline. Besides, we can see from his writings that he even hinted some kind of medium term trading (trading secondary reactions). He had a newsletter advisory service (which was very successful until his death in 1939) and published a book bearing the modest title “The Dow Theory”. In my opinion such book is the “Bible” of the Dow Theory. Any serious practitioner of the Dow Theory should read it three or four times and be prepared to look it up almost every day. I would label Rhea’s Dow Theory flavor as “The primary-cyclical trend flavor”. The investments made following Rhea’s axioms tend to last on average ca. 2 years.

After Rhea’s death the Dow Theory fell into disrepute because many alleged “experts” (history repeats itself as “experts” in Dow Theory always abound) attempted to reduce the Dow Theory to a trading system and failed miserably.

As a reaction to such excesses, the next Dow Theorist, Schaefer, proclaimed the “New Dow Theory”. In his book “How I helped more than 10000 investors to Profit in Stocks”, written in 1960, Schaefer subtly criticizes Rhea and Hamilton for not having respected the integrity of Dow’s thoughts by reducing the Dow Theory to a mere technical timing system decoupled from any consideration to values (criticism that, in my opinion, is not fully true). Schaefer stressed the importance of the secular trend (which in his opinion may last even 14 years) and recommends riding in its integrity the secular trend. Such extension of time frames resulted in a concomitantly extended definition of primary and secondary movements.

 Schaefer claims that he is the true interpreter of Dow’s writings and indicts Rhea and Hamilton as heresiarchs that have produced a “flavor” much more short term oriented with utter disregard for values. While I am not in a position to brand Schaefer as the true prophet or as a heresiarch himself, I can label his Dow Theory flavor (which bears little resemblance with Rhea’s) as the “Secular trend flavor”. The Schaefer “flavor” of the Dow Theory may result in investments lasting a whooping 14 years. Schafer had an untimely death in 1974. More about him in future posts.

In parallel to Schaefer (he got started in 1958) and continuing to this day we meet Richard Russell author of the famed “Dow Theory Letters” which you can find here 

Russell is so relevant to the Dow Theory that he doesn’t deserve a cursory review. Furthermore, his Dow Theory “flavor” is difficult to catalogue. Whereas, unlike Schaefer, he doesn’t eschew “short term trades” and, accordingly he sets a stop loss, on the other hand, he may ride a secular trend according to market conditions. But such flexibility results in not being easy to label Richard Russell’s flavor of the Dow Theory. 

To be continued next week.

Have a nice weekend.

The Dow Theorist

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