Thanks a Lot, Dow Theory

The Dow Theory -- a popular market-timing theory -- says that the bear market has finally ended. The problem for investors, however, is that by the time the theory gave its buy signal, you had already missed out on most of the bargains the market served up along the way.

According to some commentators, the long-followed Dow Theory recently signaled the end of the downturn in stocks. With Friday's gains, the Dow Jones Industrial Average joined its transportation counterpart in reaching its highest levels in three months. These "significant new highs" reverse the theory's sell signal from last November.

Great in theory, lousy in practice
As with many market-timing systems, the idea behind the Dow Theory is pretty simple. Stocks in different sectors of the economy often move independently from each other, so just because one Dow average makes a new high doesn't necessarily mean that the whole market is doing well. When both industrials and transport stocks do well at the same time, however, that suggests a more unified advance in the broader market.

However, while the thinking behind the Dow Theory may make common sense, it doesn't always work so well in practice. Waiting for both averages to confirm a trend means that you'll often miss out on substantial gains before you get a signal. Consider, for instance, these stocks from the Dow:

Stock

Price at Sell Signal

Price at Buy Signal

Lowest Price

Coca-Cola (NYSE:KO)

61.57

60.11

57.03

Caterpillar (NYSE:CAT)

67.93

85.28

62.19

Wal-Mart (NYSE:WMT)

45.31

56.31

44.62

McDonald's (NYSE:MCD)

57.33

58.30

50.41

Source: Yahoo Finance dividend adjusted closing prices. Sell signal on Nov. 23, 2007; buy signal on April 18, 2008.

As you can see, in many cases, following the Dow Theory buy signal meant paying more for stocks than they were worth months before, when the theory told you to sell. What's more, you missed out on even lower prices that were available during the downturn.

When you look at the Dow Transports, you see much the same pattern:

Stock

Price at Sell Signal

Price at Buy Signal

Lowest Price

FedEx (NYSE: FDX  )

93.40

96.71

82.55

Landstar System (Nasdaq: LSTR  )

37.94

52.50

36.68

Union Pacific (NYSE: UNP  )

123.77

138.08

108.64

Lesson learned
It's clear and simple: If you want to maximize your profits, you can't afford to wait for the all-clear signal to sound. Sure, you might feel more comfortable putting your money to work once everyone believes the worst is over. But you'll pay a much higher price for stocks if you don't take advantage of negative sentiment while it lasts.

Trying to time the market is generally a loser's game. Even when market-timing systems work, they don't necessarily give you the results you expect. Combine that with the times you'll guess completely wrong, and you can see why it makes more sense to invest while you can still find bargains.

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  • Report this Comment On May 27, 2008, at 10:47 PM, mddocmd wrote:

    Well at least for Bear signals nowhere does the Dow theory imply waiting for a signal before selling. See page 35-36 of the Dow Theory Today by Richard Russell.

    Nothing in the writings of Hamilton or Rhea remotely suggests such a dangerous method of operation. On the contrary..."It is my belief that the best market strategy for investors to study and practice is the art of retreating when secondary reactions are developing...

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