10/08/2010
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In this article we are going to revisit Dow Theory -- the grand-daddy of all portfolio strategies and then compare it with more modern approaches. We will look at Shiller, a long term but newer approach and then modern portfolio theory which is based on asset allocation.
The Dow Theory is one of the most venerable strategies. It uses the price trends of the Dow Jones Industrial index (^DJI) and the Dow Jones Transportation Index (^DJT) to decide whether to invest in the stock market.
The Dow Theory has been around for almost 100 years, yet even in today’s volatile and technology-driven markets, the basic components of Dow theory still remain valid. Developed by Charles Dow, refined by William Hamilton and articulated by Robert Rhea, the Dow Theory addresses not only technical analysis and price action, but also market philosophy. Many of the ideas and comments put forth by Dow and Hamilton became axioms of Wall Street.
Today, there are a variety of strategies
There are multiple interpretations of the original Dow Theory. This strategy represents a typical version: all the buy and sell signals are confirmed by both the Dow Jones Industrial Average and Dow Jones Transportation Average.
The Dow Jones Transportation Average is used to triangulate the Dow Jones Industrial Average to ensure that an upward or downward trend is not just a localized phenomenon.
The buy signal
- A primary low is established
- A secondary bounce
- A pullback of around 3% but above previous lows
- Both averages hold above the prior lows
- Both averages exceed the secondary bounce
The sell signal
- A primary high is established
- A secondary drop
- A rally of over 3% but falls short of the previous high
- A drop of both averages below the previous drop
The funds in the portfolio are (ETF alternatives):
- Wilshire 5000 total return index ^DWC (VTI, SPY, IWM)
- Cash (BND)
This is a long established strategy and should be reviewed to see how it performs in more recent operating conditions. To achieve this, we will compare results with another long term plan – Shiller, a modern portfolio (a 6 asset SIB with tactical asset allocation) and the total market (^DWC). 
Click here for the interactive graph
Historical Returns for Dow Theory, Shiller and 6SIB TAA
| Annual Returns |
1 Year |
3 Years |
5 Years |
| Dow Theory |
-14% |
-12% |
-2% |
| Shiller |
8% |
16% |
11% |
| 6 SIB TAA |
9% |
10% |
13% |
The Dow Theory has not been effective in the last ten years given the prevailing market conditions. It is possible that a different investment portfolio would perform better but given that Shiller is using similar funds, Shiller appears to be a better choice.
Today, Dow Theory is signalling
Takeaways:
- Both the Dow Theory and Shiller are based on long term indices and both of them outperform the market
- Shiller performs better as we recover from the nightmare of the last few years
- Modern portfolio theory based on diversification and tactical asset allocation consistently outperforms the other strategies – within the measurement timeframe
labels:investment,
Symbols:VTI,SPY,IWM,BND,AGG,DBC,EEM,EFA,GSG,IYR,LQD,SHY,TLT,Bonds,Dollar/Currencies,Earnings,Economy,Hedge,Funds,
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