Dow Theory Flavors

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

As investors it is important to know the true implications of the Dow Theory. Are we going to invest for the long pull, forever, 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. You will never become a successful investor if you don’t know your time frame and what can you expect from it. 

 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?

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

The answer is elusive as we will see in the following lines.

I.  From Charles Dow to E. George Schaefer.

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 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 named “Dow Theory Commentary” which was very successful until his premature 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. Nihil novum sub sole (nothing new under the sun).

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.

In parallel to Schaefer and continuing to this day we meet Richard Russell author of the famed “Dow Theory Letters” which you can find here 

He got started in 1958. 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.

Part II. Richard Russell and his Dow Theory Letters.

Russell is a living legend. He is greatly influenced by Schaefer but, in my opinion, Russell is more pragmatic and, without meaning disrespect for Schaefer, a more rounded up Dow Theorist and investor. If you read Schaefer’s book you’ll see that, under the guise of subtle criticism, he really believed that his “New Dow Theory” was the orthodox Creed and that Rhea and Hamilton were wrong. Furthermore, he hints in his book that they might have psychological issues because they relied heavily on a “system”. However, Schaefer failed to see that thanks to a “system” Rhea, and to a lesser extent Hamilton, had clear rules that told them when to run for the exits. In a secular bull market, such as the one experienced by Schaefer from 1949 to 1960 when he wrote his book, a “system” may look superfluous because the rising secular tide poses no real threat to one’s capital integrity. However, when a really vicious bear market sets in, the investor needs “rules” or a “system” to get him out. Capital protection is the first rule. One needs a yardstick to know when “enough is enough”. Absent the yardstick your losses are open-ended.

Schaefer provided very useful insights, though; insights that the old pragmatic Russell integrated into his own flavor of the “Dow Theory”. However, after having read Russell’s book and most of his Dow Theory Letters dating back from 1958, I can see that Russell is a very intelligent man. Too intelligent to proclaim that “his” Dow Theory flavor is the only right one. By the way, if you are serious about learning Dow Theory and, more importantly, how to think like a successful investor, you can get all the Dow Theory letters published by Russell  here 

Thus, Russell’s flavor of the Dow Theory doesn’t lend itself easily to be cataloged. I can safely say that Russell pays lot of attention to values and tends to invest along the secular trend (here being a follower of Schaefer) whenever possible. However, he’s got a built-in survivor instinct which makes him heed the technical warnings of the Rhea flavor of the Dow Theory when needed. Thus, if your google “Dow Theory Letters” you will see that his website tag reads “Follows the Dow Theory market timing system”. Well, this emphasis on “timing” has a distinct Rhea smell. We could say that Russell’s Dow Theory is a very flexible one. He tries to side with the secular trend, but he is not oblivious to the cyclical bull and bear markets that occur within it. Unlike Schaefer, he will not doubt to run for the exits if the technicals convince him that, in spite of valuations, the market structure signals a primary cyclical bear market. Furthermore, Russell follows the motto “when in doubt, stay out”, so he always errs on the side of caution.

Furthermore, Russell is a man with a very big picture. His “advice” does not merely relate to the stock market but he also actively recommends his subscribers to invest in gold (when the time is right, as now) and even diamonds. He is a seasoned investor with good knowledge of economics. And he’s an excellent writer. He knows his craft.

His latest great call was in 2008 when, according to the Rhea “flavor” of the Dow Theory, he advised investors to get out of all stocks because a primary bear market had been signaled by the Dow Theory. This market call was the turning point for me to become much more “technical” than “fundamentalist”, since I saw firsthand the way many “fundamentalists” got killed by the bear market. This was especially so, when, after reading Russell and after filtering him with my own understanding of the Dow Theory, I was convinced that an ugly primary bear market had begun. Thus, on his Letter 1437 of March 19, 2008 he wrote:

“I just read a four-page treatise by a very successful analyst in which he demonstrates based on the fundamentals, why the economic situation in the US is basically healthy. This analyst may be absolutely correct, and I’ll admit I was impressed by his analysis – but I trust the market more”.

The old fox Russell knew better than the analyst.

Russell’s uniqueness, makes evaluating his track record an elusive task. Do we count gold in the mix? Only stocks? After studying him intently for many years I can only say that those that followed his advice (including of course buying gold since the early 2000’s) have fared very well. My BOE calculations tell me that his performance in the last 10 years may have averaged ca. 10% and more importantly, he helped us keep our powder dry when the tough times (2008) came.

Russell also developed in 1969 the so-called Russell’s “Primary Trend Index” (PTI). While not being this index strictly based on the Dow Theory it served Russell well. Such index which tries to gauge the primary trend of the stock market has shown an uncanny ability to be on the right side of the market and as Russell himself says “the PTI is smarter than I am”. While providing hints as to the composition of the PTI, Russell keeps secret its specifics. Of course, Russell’s PTI has nothing to do with the Dow Theory and it is merely a timing indicator.  Personally, I don’t use Russell’s PTI because I cannot trust an indicator whose details are unknown to me. I don’t like “black boxes” even if they come from reputable investors. As of this writing, whereas Russell is bearish on stocks (but bullish on gold), his PTI has been stubbornly crying “bull market”.

By writing this eulogy of Russell I am not meaning he’s always right. Dow Theory is not an exact science. But the mark of a good Dow Theorist, or any investor for this matter, is not to be “in the money” in each market forecast but rather, after long time periods (let’s say 10 years) protect his client’s capital and, if possible, help them achieve positive returns. Thus, in the rare occasions he’s not on the right side of the market, he’s intelligent enough not to have an ego and to change gears when subsequent market action proves him wrong. As a consequence, his flexibility results in avoiding serious damage to his followers.

While my overall assessment of Russell is very positive, I don’t mean I always agree with him. On several instances, and after having followed him for many years, I didn’t agree with his analysis and conclusions. This is precisely what prompted me to become a Dow theorist myself. To put money on the line I wanted to develop my own independent judgment, even though I continue to read Russell to this day. I wanted to be able to analyze the market by myself without needing Russell’s Dow Theory letters crutch. But this is the subject for another post.

Part III. Jack Schannep and “The Dow Theory.com Newsletter”.

The latest addition to the “Dow Theory’s Hall of Fame” is Jack Schannep.

He started in the ninety sixties as a stock broker with Dean Witter in Phoenix. In 1962 he created a market timing letter which was almost privately circulated (to clients of an investment house). After retiring in 1984 he started his newsletter service as we know it now.

Schannep is a seasoned investor with many investment battles behind. He is an investor with profound “hands on” market experience. He runs an advisory service based on the Dow Theory which you can find here

He also published a book; an excellent one, indeed, named: “Dow Theory for the 21^st Century” which you can find here

Schannep has a kind of Rhea or “Primary-cyclical Trend flavor” updated and seasoned with some very valuable timing and street smarts. He definitely ignores the “secular” trend and the investments made as per his interpretation of the Dow Theory have an average duration of approximately 2 years.

As to values, I’d dare to say that he’s skeptical. This is why I label him as the purest Rhea follower. In his book, the only reference to values seems quite disparaging. He laconically says:

“We all know it is better to buy stocks when they are obviously cheap and sell them when they are obviously dear, but the Dow Theory has no such requirement in its makeup (…) I say let the Dow Theory speak for itself and follow the signals whenever they may occur. Do not let personal preferences interfere”.

Source: “Dow Theory for the 21^st Century”, page 50, Wiley & Sons, 2008.

I know that the “secular” flavor Dow Theorists would indict Schannep as heresiarch for his utter disregard of the secular trend and, with it, the need to resort to values. Although, I will develop further this aspect in future posts, the longer the timeframe, the greater the need for considering fundamentals and values. On the other hand, the shorter the timeframe, the more important is the technical condition of the market. The extreme is found in short term trading (let’s say: 1 week trades and less) were the technical structure overrides all value or fundamental considerations.

However, Schannep’s publicized track record is too good to be excommunicated from the Dow Theory fraternity. After having read his newsletters and book countless times, I can only say that I find more orthodoxy in him than in many self-appointed Dow Theorists who consider themselves the guardians of the Dow Theory orthodoxy. And I defend Schannep not because of his outstanding track record but because I honestly think that his “flavor” doesn’t contradict the work of Hamilton, Rhea and even Russell when Russell sees fit to disregard the secular trend.

Furthermore, Schannep was not caught wrong-footed when the bear market of 2008 started. On February 1, 2008 Schannep went fully in cash, thus proving outstanding timing skills. Those that followed him emerged from the bear market almost unscathed.

His timing skills shined again when on April 2, 2009 he went 100% invested in stocks. Subsequent market action proved again Schannep and his Dow Theory “flavor” right.

 But Schannep’s accomplishments go beyond excellent market timing. Schannep has really made a valuable contribution to the Dow Theory. He’s made in depth studies concerning the average duration of bull and bear markets, the gains (losses) that can be expected as a bull (bear) market advances, alternative ways to define primary bull and bear markets, how to appraise secondary reactions, etc. He has honed Dow Theory to make it the closest thing to a science. Personally, I’ve been greatly influenced by Schannep.

As I said, Schannep makes an orthodox application of the Dow Theory, albeit with a strong emphasis on the technical action of the market. Although his newsletter is seasoned with fundamental market data, the final decision as to whether one should buy stocks or sell them relies exclusively on his Dow Theory interpretation, being the fundamental data displayed in each issue of his newsletter a mere dressing or appetizer. He has done groundbreaking work in clarifying the extent and duration of primary bull markets and secondary reactions, thereby providing the Dow Theory investor with a clear roadmap as to what to expect. In other words, he helps put a “figure” to the expected gains and losses derived from taking the buy and sell signals and the most likely time-frame it will take to play out. By doing this, he has expanded the work that was initially started by Rhea.

Furthermore, he has made two additions to the arsenal of the Dow Theory consisting on:

a)     Definition of primary or bear market in the rare instances when under classical Dow Theory market action hasn’t provided a signal yet. As I will write in a future post, there are several kinds of market setups for a primary bull (bear) market signal. In some cases, the market continues to go up (or down) without providing a Dow Theory signal. And here comes Schannep to our help.

b)     Addition of the S&P as an index worth monitoring under Dow Theory. He makes a compelling case in his book about the importance of adding the S&P as the third index to be monitored and taken into account in order to determine the existence of a Dow Theory primary bull (bear) market signal.  The well grounded addition of the S&P addresses the common criticism against Dow Theory that runs as follows: “The Dow Theory is no longer responsive enough because the Transports are not significant anymore”.

If one thinks it over, we can see that Schannep’s additions are not to be labeled as a heresy. They merely reflect the evolution of the markets across time (i.e. the S&P didn’t exist in the times of Dow). I am convinced that Schannep’s additions result in a significant improvement of performance and a concomitant reduction of risk (capital loss) because they increase the responsiveness of the Dow Theory by improving the timing when signaling primary bull and bear markets.

The only addition made by Schannep I don’t buy into, is the “Schannep Timing indicator”. In a similar fashion to Russell, Schannep developed his pet indicator which, together with the Dow Theory, helps him time his buy and sell signals and the amount to invest. While I don’t discuss the merits of the indicator and I consider it as good as Russell’s PTI, I feel leery to entrust my investment fortunes to a “black box” indicator. Even though Schannep makes some work explaining how the indicator works, he doesn’t even come close to a full disclosure and, hence, I discard it as not compliant with the “Dow Theory”. Besides, Schannep’s “flavor” of the Dow Theory is so good that even without use of his “Timing Indicator” results keep being very good (and don’t forget less overfitted). So, personally, I’d rather settle with 2% lower annual performance that results from strictly applying Dow Theory (with its robust +100 years track record) rather than applying an indicator whose bowels are unknown to me.

Schannep is purely an equities man. His investment advice is geared exclusively to stocks and in this field his proven track record is outstanding (ca. 6.8 % annual exclusive of dividends with reduced draw-downs in the last difficult 10 years is more than an accomplishment). As an investor, Schannep is like a specialist shop. He’s the best in equities; however, if you want to set up a portfolio, you need advise that goes beyond equities. Here is where my value considerations tell me that betting one’s ranch all in stocks may be a dangerous proposition. Personally, I feel better with a mix that includes the precious metals universe and this is why I write a lot about such markets with the aid of the Dow Theory and I also keep an eye on values in the timeframe where they really belong.

Part IV. Recap and main tenets of my own “flavor”.

All in all: If you want the best advice, follow both Russell and Schannep. Both are great Dow Theorists and both are alive. Take advantage of it!

Is any one of the Dow Theory “flavors” we have hitherto analyzed to be excommunicated from the Dow Theory fraternity? Personally, I think that all of them loosely fit under what we can define the basic Creed of the Dow Theory. Some styles place greater emphasis on the secular trend and values; others focus on riding the primary trends and are more technical in nature.

However, from the preceding discussion we can see that it is important to know what kind of flavor we mean. The investment results (and drawdowns to be endured) accruing to an investor riding the secular (10-14 years) trend will differ substantially from those affecting an investor following the cyclical bull and bear markets (whose median duration is ca. 2.5 years). In another post, I’ll dissect the advantages and disadvantages of each method. Here it suffices to say that, while not disparaging any of such “flavors”, it is important to know were we stand and what do we mean when we say “bull market under Dow Theory”. What is a bull market: 3 months (secondary trend), 2 years (primary trend) or 14 years (secular trend)? Our wording and definitions are important.

My conclusions are as follows:

·        There isn’t just one “right” or official Dow Theory.

·        There are some flavors which, provided, they respect the basic tenets of the Dow Theory are acceptable. Each “flavor” has its own pros and cons and its use depends on the temperament and personal circumstances of the investor (more on this in another post in this blog).

·        The basic tenets of the Dow Theory, which all acceptable “flavors” have in common, are the belief in trends, the existence of primary and secondary movements (even though there is some disagreement as to the duration of each), the importance of previous highs and lows (although there is also disagreement in determining which highs or lows are the relevant ones) and the principle of confirmation for a signal to be valid. This is the basic “Creed”.

·        Together with the acceptable “flavors” of the Dow Theory co-exist real heresies which deny the basic “Creed”. Heresiarchs are those that deny the principle of confirmation, that apply Dow Theory principles to short term trading (as the main strategy), those that say that the Transports should fell into oblivion, or those that bluntly say that the Dow Theory doesn’t’ work any longer. As we advance in this blog I will expose some of these adulterated dow theorists (with lower case). It is because of these heresies that the real Dow Theory gets occasionally bad press.

·        My personal “flavor” of the Dow Theory is deeply influenced by Russell and Schannep (and indirectly by Rhea). I define “primary” and “secondary” movement very much in the sense of Rhea which results in investments with an average duration of ca. 2 years. I keep an eye on values and fundamentals but, I’m extremely demanding as to what constitutes “good values” and extremely skeptical as to my ability (or anyone else’s, by the way) to accurately determine “values”. More on “values” and fundamentals in a future post. Borrowing from the world of trading and its obsessive quest to look for the best risk reward ratio (RRR) trades, I place special emphasis in finding good RRR investments. Risk must be commensurate with potential gain. All these aspects are vital to succeed as an investor and will be further developed in this blog.

·        However, I part company with Russell or Schannep in that I rely exclusively on the Dow Theory to determine a buy or sell signal. I don’t want to use extraneous black box indicators which, albeit useful, are not endowed with the 112 track record of the Dow Theory. I am convinced that, if one is well prepared and works diligently, investment results can be more than satisfactory by simply applying the Dow Theory. I’d rather prefer to be proficient in just one thing (Dow Theory) than dabbling with many indicators.

Sincerely,

The Dow Theorist