Dow Theory shows market turmoil isn't signaling a coming crash

Mark Hulbert | Special to USA TODAY

Show Caption Hide Caption Remember these facts when the market takes a hit The good times can’t last forever. After the stock market was on a tear in 2017, it now appears that “volatility” lies ahead.

Panic is a bad investment strategy.

Yet that is exactly how many investors reacted this month when the stock market dropped precipitously. They indiscriminately dumped their stocks at whatever prices they could get.

Odds are good that they will end up regretting their behavior.

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I say that not just because the stock market has recovered some over the last few sessions. It is still possible that a bear market did begin from the late-January market highs. But since most scary drops do not lead to major bear markets, it’s virtually assured that — over the long term — selling after every unnerving decline will lead to more losses than gains.

If you’re not a long-term buy-and-hold investor, therefore, you need an investment system that keeps you from panicking every time the market starts heading south. The Dow Theory is the oldest and perhaps the most popular of such systems. Like any good investment discipline, it provides you with preset rules that try to differentiate between less serious bouts of market volatility and the beginnings of devastating bear markets.

Currently, followers of the Dow Theory are giving the stock market the benefit of the doubt.

The Dow Theory was created in the early part of the last century by William Peter Hamilton, then editor of The Wall Street Journal. He introduced the strategy in a series of editorials in the newspaper up until his death in 1929. He advised readers to focus not on the initial pullback from market highs but on the market’s attempt to recover from that pullback. A bear market signal would be triggered if that recovery were so weak that either the Dow industrials or the Dow transports would fail to close above their previous highs, and then both Dow averages would break below their lows hit in the initial pullback.

Here’s how that applies to the current market: If in coming weeks the Dow industrials surpass their Jan. 26 closing high of 26,616.71 and the Dow transports close above their Jan. 12 record finish of 11,373.38, then the Dow Theory would consider the bull market alive and well.

By contrast, a bear market signal would be triggered if either the Dow industrials or transports couldn't beat their January highs, and both close below their early February lows — 23,860.46 in the case of the industrials and 10,136.61 for the transports.

Until then, Dow Theorists wait, letting the market tells its story. And one of the key tenets of Hamilton’s approach is that the market’s major trend is presumed to remain in force until formally reversed. That’s why the Dow Theory currently is giving the bull market the benefit of the doubt.

Note carefully that the Dow Theory isn’t designed to catch the exact tops and bottoms of bull and bear markets. By requiring a decline from market highs to prove itself before a bear market is declared, for example, the strategy is guaranteed to suffer losses at the beginning of a bear market. The same goes in reverse when a bear market gives way to a new bull market.

But there never has been a market timing system that consistently catches the exact day of bull market tops and bear market bottoms, and there never will be. And the perfect is the enemy of the good. Jack Schannep, editor of TheDowTheory.com, one of the country’s leading Dow Theorists, put it this way: “The genius of investing is recognizing the direction of the trend — not catching the highs or the lows.”

One confirmation of the Dow Theory’s value comes from a study conducted in the 1990s by three finance professors — Stephen J. Brown of New York University, William Goetzmann of Yale University and Alok Kumar of the University of Miami. They tested the Dow Theory over the nearly 70-year period from 1930 (the year following Hamilton’s death) to the end of 1997, finding that it beat a buy-and-hold by an annual average of 4.4 percentage points per year.

Financial advice after the Dow plunge The Dow Jones industrial average plunged more than 1,100 points Monday as stocks took their worst loss in six and a half years. (Feb. 5)

Mark Hulbert, founder of the Hulbert Financial Digest, has been tracking investment advisers' performances for four decades. For more information, email him at mark@hulbertratings.com or go to www.hulbertratings.com.