#67 S2N: Dow Theory

micksonmatch
May 24, 2024

S2N Spotlight

One of the most influential people responsible for my passion for the markets was famed newsletter writer Richard Russell. He wrote the longest continuous newsletter, Dow Theory Letters, 57 years without missing an issue. He died at the age of 91 in 2015. Close to the end, he was still writing, and I can recall him writing with such excitement, wondering how things would play out wishing he would live longer to find out. Russell was such a character. He was married 3 times, had 5 kids, fought in WWII, and rode a Harley Davidson into his 80’s.

I was introduced to him by my brother-in-law Dani, another market enthusiast in my early 20’s. I would go on to read his almost daily letters religiously for more than 15 years. I recall on the trading floor during my investment bank prop trading days a bunch of us running to the printer to get a copy when we would print out our single subscription 10 x, we just wanted to spread the love. Those were very different days, where there was a dirth of folksy financial market commentary. We would get a cup of coffee put our feet up on the desk and shout out one liners acting like kings of the world.

Richard Russell’s process was he would get up around 4:30am on west coast and read 10 newspapers. He would then write about the markets using his lens of experience and insight. He was more than just a commentator, he was also a diligent analyst. His main process revolved around Dow Theory analysis.

The title Dow Theory Letters reflected Russell’s lifelong interest in the market observations of Dow, who created the Wall Street Journal in 1889 and penned his principles in a series of editorials from 1899 to 1902. One Dow principle holds that a stock-market rally relies upon transportation and industrial equities both surpassing recent peaks.

“I’ve spent two-thirds of my life studying and writing about the markets,” Russell wrote on his website. “And I’d say that without a shadow of a doubt the material which has served me best are the books and papers written by the great Dow Theorists — Charles H. Dow, William P. Hamilton, Robert Rhea and E. George Schaefer.”

I wrote about a week ago that the Wall Street Journal believes the Dow Jones Industrial Index (DJI or Dow) is no longer relevant. Having said I noticed earlier in the week that the Dow Jones Transport Index was not confirming the recent series of Dow highs. According to Dow Theory this is a fracture in the market and increases the probability of large top. I was too lazy to mar all the instances on the chart below. I have marked a few on a weekly chart of 100 years of data. I have also added a zoomed in chart to get a closer look.

We know that the markets are much more about technology these days than industrials and transports so I am not 100% sure we can rely on this index anymore, and it might be more suitable to replace the indexes with more relevant ones. I do think we are close to a top so I think the Dow Theory non-confirmation may get renewed interest, but I would be very wary as it is easy to attribute a random correlation with causation.

We are expensive on a forward earnings basis, or on a historic trailing 10-year Shiller PE basis. Over the last 100 plus years of market data, we have lived through an industrial revolution, a transport revolution, a technology revolution, an information revolution, and now an AI revolution. Over all this time, the market has averaged around 7.5% compound annual growth. We are already up 10% this year, and its only May, last year we were up 23%. I think we are near a top simply because markets are extremely highly valued, and I am a reversion to the mean kind of guy. I am pretty sure all the new technology innovation is going to add to our productivity, but it is also going to come at a cost. That cost will be jobs. Yes we are an innovative species, so we will figure out ways to use that technology to our advantage but there are some simple laws of physics that govern economics.

If I were to gaze into my crystal ball I think the world as Keynes envisaged it with more time spent pursuing leisure activities, may come to be. However, what Keynes did not discuss was the issue of morality associated with that increased leisure. I see a breakdown in society with social media part of the root cause. As a reversion to the mean kind of guy, the pendulum will eventually swing. To borrow some economic terms, there is a diminishing marginal utility to pursuing hedonism. There is a saturation point and I look forward to a swing back to more old fashioned values where we care about people more.

Wow, I had no idea I would write this, but hey, there you have it. Who knows what Friday will bring out of Dr Bearman.