Wednesday, September 12, 2012

Dow Theory predicts market decline, unless it doesn't

You may heard this analyst or that analyst rolling out the relationship between the performance of the Dow Jones Transportation Index and the S&P 500, the Dow Theory. The Dow Theory states that an underperformance of the transportation index versus the market foreshadows a decline in the market. If the Dow Theory worked in the past, I cannot say, but it does not appear to provide any consistent sell signal at any time in recent memory. The following chart shows the SPY versus the difference in the 13 week percentage change in both the SPY and Dow Jones Transports.


Do you see any consistent signal? Neither do I. However, I have worked with enough numbers and graphs to know that a graph can be misleading. So on to the numbers.

Here are the buy-and-hold forward performance statistics calculated using daily data on the SPY for various time periods since early 2004, this date was chosen as it was start date of the Dow Jones Transports ETF. 


1M 3M 6M 1y
Avg 0.5% 1.6% 3.4% 5.8%
med 1.3% 2.7% 5.0% 9.2%
Max 26.9% 39.6% 55.8% 72.7%
Min -29.4% -40.5% -46.4% -47.3%
% Up 62.5% 63.5% 68.5% 76.0%





This compares to the forward performance statistics calculated when the Dow Theory is flashing a supposed sell signal.


1M 3M 6M 1y
Avg 0.7% 2.6% 6.0% 7.2%
med 1.3% 2.4% 5.3% 9.2%
Max 26.9% 39.6% 55.8% 72.7%
Min -23.6% -23.0% -25.1% -46.7%
% Up 61.0% 63.9% 66.2% 73.5%




Do you see market underperformance following a Dow Theory sell signal? The Dow Theory appears to fail on nearly every measure. Not only is the average performance over all time periods better than the buy-and-hold case, but the data suggests a positive performance skew. Not what you want to see in a sell signal.


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