Dow Theory of inter-market confirmation
Summary
One well known and quite profitable investing system that has been back tested over many decades is the Dow Theory of inter-market confirmation. The version outlined here with PPO as a momentum indicator is simple and captures most of the gains with little of the risk since the 1980's under many market conditions. The Transports turned technically negative and gave a long-term investing signal to Reduce on Strength since Dec. 31, 07. Until late 2009, Relative strength cycle studies suggest we shift our allocation more to the Dow Industrials and less to the Transports and possibly the Utilities as well but no sign of a turn there yet.
Investing Methodology
Charles Dow's precept was simple: if the economy is performing well, then he expected the Industrials and Transports to do well together. As such he looked for them to be trending and making new highs or lows together to confirm a primary Bullish or Bearish trend.
Today the situation is a lot more complex with most manufacturing being done in Asia, but the Industrials are still a significant sampling of the US and other economies, and with global trade the Transports are more important than ever. Since his precept was about measuring a Bullish or Bearish primary trend, I use momentum indicators on all three major Dow indices to confirm a strong Bullish or Bearish trend. Signals are generated from the monthly charts for more long term investing.
When all three indices show positive PPO we have an Hold Equities signal, with one index negative we have a Reduce on Strength signal or Accumulate on Weakness (when coming from a low), with two indices negative we have a Wait in Cash signal, and when all three indices are negative we have a confirmed Short on Strength signal. The system is rarely short and quick to cover since the markets typically go up with inflation over the long term.
| Signal Date | Investing Signal | Dow Index | Index Value | Dow Value | |
| Dec 2007 | Reduce on Strength | Transports | 4570 | ||
| Nov 2003 | Hold Equities | Utilities | 250 | ||
| Aug 2003 | Accumulate on Weakness | Industrials | 9416 | 9416 | |
| Jul 2003 | Wait in Cash | Transports | 2623 | ||
| Jul 2001 | Short on Strength | Utilities | 350 | ||
| Feb 2001 | Wait in Cash | Industrials | 10495 | 10495 | |
| Nov 1999 | Reduce on Strength | Transports | 2910 | ||
| Sep 1995 | Hold Equities | Utilities | 214 | ||
| Feb 1995 | Accumulate on Weakness | Transports | 1596 | ||
| Nov 1994 | Wait in Cash | Transports | 1443 | ||
| Jan 1994 | Reduce on Strength | Utilities | 226 | ||
| Jan 1991 | Hold Equities | Transports | 1069 | ||
| Nov 1990 | Accumulate on Weakness | Industrials | 2560 | 2560 | |
| Sep 1990 | Wait in Cash | Industrials | 2453 | 2453 | |
| Aug 1990 | Reduce on Strength | Transports | 901 | ||
| Apr 1989 | Hold Equities | Utilities | 192 | ||
| Jan 1988 | Accumulate on Weakness | Transports | 764 | ||
| Dec 1987 | Wait in Cash | Industrials | 2169 | 2169 | |
| Oct 1987 | Short on Strength | Utilities | 183 | ||
| Oct 1987 | Wait in Cash | Transports | 757 | ||
| Oct 1987 | Reduce on Strength | Industrials | 1994 | 1994 |
Charts courtesy of StockCharts.com
Charts courtesy of StockCharts.com
Using relative strength to maximize buy and hold profits
The 4 year cycle is even more apparent in the relative charts of the Dow Theory components, and we can use asset allocation to increase our rate of return on long term retirement funds. We can use a basket of stocks or sector funds to increase our exposure to the most favored component while decreasing our exposure to the weakest one. Until late 2009, Relative strength cycle studies suggest we shift our allocation more to the Dow Industrials and less to the Transports and possibly the Utilities as well but no sign of a turn there yet.
Charts courtesy of StockCharts.com
Charts courtesy of StockCharts.com