Dow Theory – Ignore It

There are many ways to criticize the Dow Theory. My favorite way is to say that the idea that stocks predict the future of the economy is often absurd. What exactly was the NASDAQ 100 predicting about the economy in March of 2000? It was predicting a massive boom, when in reality we got a recession. Stocks could not have been more wrong. And if you look at the charts for 2001, you will see a few very strong bear-market rallies wrongly predicting the end of the recession.

Stocks most definitely can predict the future of individual companies when people with inside information buy or sell before the news is released to the public. But who has inside information about the economy as a whole? Nobody.

As we have seen many times throughout history, stocks are often a better indicator of mass hysteria than they are of the economy.

Dow Theory is Antiquated

The original Dow Jones industrial and transportation averages had to be calculated by hand since they didn’t have computers back then. That probably took a lot of time and expense, and instead of just creating one combined index, investors obsessed over the two indexes trying to see if they were confirming each other’s movements.

Today, our computers crank out no end of different indexes to chose from. We still like to look for confirmations amongst various indexes, however there is no lack of broad-based indexes, such as the Wilshire 5000, to look at if you think that they can predict the future of the economy.

The original idea of the Dow Theory was to assess the prospects of industrial firms and the railroads that shipped their products to market. Today, the transport index includes airlines which ship people rather than widgets. It’s quite a different thing. And of course, many modern products such as software are not transported in trains, trucks, ships, or airplanes at all, but are downloaded over the internet.

While it is tempting to believe in a magic indicator that can predict the future of the stock market, there is no such thing. While human nature remains the same, the economy that we create changes very rapidly.

Note: I am criticizing the Dow Theory signals generated by comparing the DJIA and DJTA. I am not criticizing the remainder of technical analysis.

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