Can Dow Theory be applied to foreign and to non-stock markets?

This “Dow Theory Investment” blog is gaining traction and, to be sincere, it is attracting more following than I initially expected. Unjustly, the Dow Theory tends to be badmouthed, and hence I thought it would be a dull subject for most readers. So I am happy to see that there is a growing readership. My efforts do not go to naught. The Dow Theory investment blog seems to be gaining a life of its own as the feedback I receive through emails and comments provide me with clues as to what really interests my readership.

Thus, on Friday October 5, “Remoc” posted an interesting comment, namely:

“I'd be interested in your opinion of whether the Dow Theory could be applied to foreign indexes, such as EAFE […]”.

This prompted me to write this post.

Dow Theorist Hamilton in his 1922 book “The Stock Market Barometer" wrote:

"The law that governs the movement of the stock market, formulated here, would be equally true of the London stock exchange, the Paris Bourse or even the Berlin Boerse. But we may go further. The principles underlying that law would be true if those Stock exchanges and our were wiped out of existence [...]"


As to whether Dow Theory can be applied to gold and other markets, Hamilton said:

"The averages of South African mining stocks in the Kaffir market, properly compiled from the first Transvaal gold rush in 1889, would have an interest all their own [...] The comparison of that average with the movement of securities held for fixed income would be highly instructive to the economist."

Source: William Peter Hamilton, "The Stock Market Barometer." Wiley Edition, pages 14-15.

In other words, Hamilton is telling us that the principles of Dow Theory may be safely applied:

a) To stock indices outside USA.

b) To specific markets different from the broad markets (i.e. bonds, stock miners, etc.).

While I tend to distrust the word “why” in investment as it prevents us from going with the flow, I think it is legitimate that the reader questions: “why the Dow Theory may be applied outside of its initial realm of US stock indices?”

To answer the question, we should bear in mind that the Dow Theory is made of two separate “components”. On the one hand, we have the “value-based” side of the Dow Theory. If you remember my saga on the Dow Theory “flavors," which you can find here in its entirety, we talked about Schaefer, the secular trend, etc. Clearly some value considerations are applicable to other countries and sectors. Dividend yield will tend to be relatively similar across comparable countries. Yields in a First World country like USA should not diverge substantially from those in Germany. Even in cases of economic disparity (i.e. a Third-world country with much higher interests rates), we can “adjust” our benchmark accordingly (i.e. considering the stock market expensive if yields fall below 5% whereas in USA dividend yields would have to decline to 3% to consider stocks expensive). However, as I will make clear in a future post, value considerations are primarily useful in appraising the secular trend (i.e. more than 10 years) and can be deceptive, when not applied together with “technical” action, since they are not carved in stone.

On the other hand, there is the purely “technical” side of the Dow Theory with its emphasis of primary movements, secondary reactions, highs and lows, etc. Although I consider the “technical” side of the Dow Theory the best ever devised technical method to gauge the trend for the next 1-3 years, it is clear that we are talking of “technical analysis” and, as such, it lends itself well to being applied to any market. Technical analysis is applicable to any organized market where there is price formation. And this is why the technical principles of the Dow Theory may be safely applied to ratios, bonds, gold, corporate sectors, different countries, etc.

The only adjustment I make, and this is a matter for another post, is the minimum requirement for a movement to exceed 3% as per “traditional” Dow Theory. When dealing with stocks indices, I stick to the traditional 3% definition. However, when dealing with more volatile markets (i.e. silver, which roughly doubles the daily volatility of the S&P), then I adjust this requirement to meet the specific volatility of the market concerned. Thus, for silver, I’d require a minimum movement of at least 5% to account for its greater volatility.

However, since the Dow Theory is based in the principle of confirmation, I apply it to markets that show some affinity or correlation. It does not make any sense to apply the Dow Theory to wheat and semiconductors. Thus, good trading results can be achieved by trading the corn and wheat markets (quite correlated) by applying the principles of the Dow Theory.

We should not forget that the Dow Theory has an uncanny ability to uncover a new emerging trend when it is in its early stages. Such ability applies to any market, and it is much more effective than applying moving averages, which are by definition almost always late. A living example is now with the stock and gold and silver market. The 200/50 moving average crossover turned bullish in late September, whereas those following the Dow Theory were already in by June 29 (stocks) or August 22 (gold and silver). So the Dow Theory signaled with many weeks in advance and many percentage points lower the advent of a new primary bull market. The subject of moving averages and Dow Theory signals is another important subject to be further developed in another post in this blog. So many subjects, so little time..:=)

Well, I hope that by now it is clear that the Dow Theory is the most powerful tool in our arsenal, since it can be deployed on many markets.

Have a wonderful weekend.

Sincerely,

The Dow Theorist.