How Successful is Dow Theory?

If you're following the market, you've probably seen this everywhere - Dow Theory is currently predicting a market drop.

From the WSJ, a good summary of this idea and how successful its been:

Some investors subscribe to "Dow Theory," which posits that share prices of airlines, railroads and trucking companies offer a glimpse of future movement in stocks across a range of industries. According to the theory, which dates back to the early 20th century, demand for goods should be reflected in the amount of cargo carried by oceangoing vessels and deliveries made to consumers' doorstops, as well as manufacturers' level of output.

A symbiotic relationship between the industrials and transports often underscores a healthy economic environment, according to this view. For some strategists and investors, that is casting a shadow on the market's recent rally. While the Dow has approached five-year highs, the 20-company Dow Jones Transportation Average has tumbled: Last week's 5.9% drop was the biggest weekly decline since November 2011. The index is down 1.2% year to date.

While transportation stocks have a mixed record as a leading indicator, some traders, investors and analysts are putting more faith in the index now. For one, the manufacturing sector has played a major role in the recent economic recovery. Also, much of the recent gain in stocks has been attributed to news about stimulus measures from the Federal Reserve and other central banks.


To be sure, investors wagering on Dow Theory have been proved wrong at pivotal moments. For example, transportation and industrial stocks were simultaneously hitting multiyear lows in March 2009, which typically would signal more trouble ahead. But the stock market bottomed that month and recovered sharply, leaving followers of Dow Theory in the dust.

A recent sell signal came this past May, according to Mary Ann Bartels, a technical analyst at Bank of America Merrill Lynch, when the Dow industrials were hitting new highs but the Dow transports failed to follow suit.

That call worked in the short-term, as the Dow industrials slumped nearly 10% from early May through early June. But the selloff proved to be short-lived: Stocks quickly recovered, and earlier this month the Dow industrials hit their highest level since December 2007.

Chart watchers and technical analysts have differing viewpoints on when Dow Theory buy- and sell-signals actually are triggered, making it difficult to analyze which indicators work and which ones don't. According to market-research firm Birinyi Associates, the theory isn't the best predictor of how stocks perform, at least over the short term. Since 1990, when Dow Theory "buy" signals cropped up, the market rose an average of 0.04% one month later. By comparison, the market was also up, by an average of 2.07%, one month after "sell" signals, according to Birinyi Associates.


Marketwatch also had this article about Dow Theory though not nearly as supported by any shown data.