Dow Theory: It's Alive! Alive! And Bullish?

The Dow transports haven't come close to confirming the new highs in the industrials, but one theorist thinks that's quite all right.
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Beginning with the concept that it's always nice to have one thing

less

to worry about, we bring you: the Bride of Dow Theory.

Don't worry, this isn't a horror story and it actually has a happy ending (at least for those long the market).

The

Dow theory, you'll recall, is one of those time-honored, traditional measures of looking at the market, which (basically) says any move in the

Dow Jones Industrial Average

must be "confirmed" by the

Dow Jones Transportation Average

. The theory has been broadcasting a bearish signal since Aug. 4, according to its best-known proponents, and that's something other pundits generally include in their litany of things "wrong" with the market.

But Jack Schannep, president of

The Dow Theory Investment Timing Newsletter, says Dow theory turned bullish Sept. 15 and remains so today.

According to purists, both indices would have to close at new all-time highs to re-establish a bullish signal. The Dow Jones Industrial Average, of course, has accomplished the feat several times since Aug. 4 -- most recently

today, when it jumped 1.6% to 10,339.51. Nearly a year later, the Dow transportation average has yet to revisit (much less surpass) its all-time high of 3686.02, set April 16. Today, the transports fell 1% to 3335.89.

Schannep, however, argues there was a "capitulation" last August, culminating in that frightful session

Aug. 31, when the Dow fell 512.61 to close at 7539.07. The

next day, the index traded as low as 7400.29, only to mount a remarkable recovery and close up 288.36 to 7827.43. Save for a few, brief reversals, the index hasn't much looked back since.

The Dow transports made a low Sept. 4 at 2617. In days following their respective lows, the Dow industrials rose 6% while the transports gained 5%. They subsequently retraced 5% and 4% of those moves, respectively, but each held above its initial bear-market low. By Sept. 15, the industrials had bounced again to 8024, above their prior "bounce high," a feat the transports accomplished the day before when they hit 2805.

At that point, "Dow theory reversed itself with a new buy signal," Schannep says.

Relying on the Rule of Three

To make the call without either index hitting a new all-time high, the newsletter writer delved into some of the more esoteric aspects of Dow theory. Specifically, he referenced the so-called Rule of Three, first espoused by Robert Hamilton, who is credited with crystallizing Charles Dow's theory about the relationship between the industrial and transportation averages. Schannep also cites Robert Rhea, author of

The Dow Theory

.

The rule says a move of 3% or more by a major average is considered "significant." In the aftermath of the Aug. 31 lows, each average moved more than the requisite 3%, both in their respective bounces and subsequent reversals.

The second half of the Rule of Three says the reaction after a low (or high) will usually last from three weeks to three months and retrace from 33% to 66% of the "primary price change" from the prior high to the new low.

At this point, Schannep's view breaks from pure Dow theory. From their Aug. 31 closing low to the reaction high of 8154.41 on Sept. 23, the industrials retraced 34.2% of what had been lost from their July 17 high to the Aug. 1 low. But the transports only retraced 26.9% of what was lost between their April high and Sept. 4 low. Moreover, the time frame for the transports' "reaction" move fell two days short of the three-week guideline.

"We don't have the time frame, but even Hamilton said it could be only a matter of days," Schannep retorts. "Also, we exceed the 3% magic number. I will admit the buy signal was aggressive because we were in capitulation. But even if you weren't

in agreement then you had to come up with a buy signal by now."

You Can't Do That

But the better-known Dow theorists have yet to embrace Schannep's interpretation or come around to his bullish way of thinking.

The man considered the dean of Dow theory, Richard Russell, editor and publisher of

Dow Theory Letters

in La Jolla, Calif., was downright dismissive of Schannep's call.

"It's not Dow theory. It's the Schannep theory," Russell says. "The next signal will be the bottom of a bear market. You don't get to a new bull market with the dividend yield at 1.6%. It's going to be a long-term bear market."

Chuck Carlson, contributing editor at

Dow Theory Forecasts

in Hammond, Ind., agrees Dow theory remains bearish but is a little more diplomatic.

"Hindsight obviously being 20-20, it's possible that

a buy signal existed," Carlson says. "Our feeling is there wasn't enough of a retest in the transports once the market came off its bottom to warrant a change in the trend."

It's not clear there was a true "capitulation" during the late-August selloff, he adds, noting while the industrials never again traded below their Aug. 31 lows (to date), the transports "went back down to new lows" of 2345 on Oct. 8. "Our feeling was, the transports going to new lows didn't confirm the industrials and their ability to hold that low," he says.

Schannep concedes the transport average's slide to 2345 was "worrisome," but claims it was "resolved favorably" when the average subsequently recovered to 2954.85 on Nov. 2. By that time, he adds, the industrials were at 8706.15 after having established a "higher high"-- above their Sept. 23 "reaction high" -- of 8299.36 on Oct. 15.

Moreover, Schannep says his peers are being too doctrinaire in sticking to the 33% and three-week levels, noting they are "guidelines," not absolutes.

Adding he does not wish to get into a "shouting match" with his fellow Dow theorists, Schannep calls their clinging to a bearish stance "ludicrous."

"I'm just saying they're giving Dow theory a bum rap sticking to this interpretation," he says. "The world has got to know this is not a bear market up 33% from the lows. When they finally admit it, it's going to take the Dow transports at new highs, which is still a couple hundred points up. That means the Dow industrials will be between 10,000 and 11,000 after making a low at 7500."

Schannep may be a maverick. But looking at the performance of both averages, it seems he's a rebel

with

a clue.