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Thursday, June 21, 2012 11:43:20 PM

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Musings on Dow and Gann Theory

I was looking at the major indices this morning, and two things were readily apparent. First, that the majority of them were hovering around the 200 day mark, testing resistance there, and apparently the market was reluctant to thrust them beyond that point. Second, that the two outliers that provided the exception to the rule were the Dow Transports and the Utilities, both of which had closed well above their respective 200 day moving averages.

The charts were ominous enough this morning that I thought to take snapshots of them. The markets were topped out, I reasoned, and were about to take a downward turn. Let's see how things turned out.

Above: Major U.S. indices this morning at 10:52 AM.

Above: Major U.S. indices on market close.

One of the giveaways this morning was the Dow Utilities Index, which was the only index of the lot to actually be in an uptrend according to the 50- and 200-day moving averages. Also, the Transports looked weak. The Dow theorist in me, as it turns out, was right to follow his intuition. Or, was I?

Are articles such as “How the Dow Jones Industrial Average and Other Major Stock Indexes Fared on Wednesday,” published a few hours ago in the Washington Post truly of some relevance, or are they only minor distractions to the trader? Indeed, many a market technician continues to rely on such benchmarks. “The strengths of Dow's Theory far outweigh any weaknesses. Dow's Theory has proven itself over the past 112 years to be a useful, sound and profitable investment approach,” writes Robert W. Colby in an excerpt of his book. “The venerable Dow Theory after more than a century has stood the test of time,” Colby explains.


In earlier versions of Dow theory, railroads held great importance as they dominated the market. The Transport Average has been since expanded to include freight companies (such as UPS and Fedex), airlines, and shipping companies. Nevertheless, the Dow Industrial Index itself has declined in significance over the years. Today, many traders instead use the Standard & Poors 500 index to confirm Dow signals. Some others ignore index-generated signals altogether, trading only individual stocks. The Dow theory also has its share of critics.

This is nothing new. In 1936, W. D. Gann observed: “For years the Dow-Jones Industrial Averages, Railroad Averages, and Public Utility Averages, have been a reliable guide to the trend of the market. Years ago when there were 12 Industrial Stocks which were representative, they were a guide to the trend of industrial stocks. When railroads were the leaders and active, the 20 Railroad Averages were a good trend indicator. But now, since more than 1,200 stocks are listed on the New York Stock Exchange, the 20 Railroad Averages and the 30 Industrial Averages are no longer representative or a guide to the average trend of the entire market.”

Gann continued on this this vein, noting that the Averages had by the 1930s become “obsolete.” He explains that while the Dow Averages worked rather well up until 1916, World War changed everything. To be a success, the trader must abandon old ideas when they become obsolete, and follow new rules and new stocks in order to be successful in the markets. One must change with the times, and adapt to following the trends of individual stocks, regardless of the actions of their industry averages.

In support of his proposition, Gann succinctly explained:

“Years ago Stage Coach Stocks advanced and you could have made money buying them, but stage coaches went out of business and so did the stocks. Then there were Canal Stocks that advanced and you could have made money buying them, but other modes of transportation reduced the business on canals. The automobiles came along and took business away from the railroads. Now the airplane is coming along and taking business from the railroads and will later take it from the automobiles and trucks. You will have to watch airplanes in future as a guide, the same as you watched automobile stocks a few years ago, because the money will be made trading in airplane stocks rather than rails or automobiles.”


Gann (p. 31) encourages his reader to “change with the times,” while noting (p. 29) that “you cannot trade in averages. You must follow the trend of individual stocks to make money.”

Just as there has been an increasing diversification among the indices since Gann's era; so is something else new since his time – the ability to trade them. One can trade the Dow by virtue of its proxy the Diamonds (NYSE: DIA); or trade the Nasdaq 100 Trust by virtue of the Cubes (NASDAQ: QQQ); or trade the S&P 500 Index by virtue of SPY.

In looking at the Transports, we find an interesting hybridization among the industry in the wake of pipelines extending many miles far further than was thought possible in Gann's era (itself a major development in transportation since his time) and the concept of a “pipeline on rails” as an alternative method of transporting crude is emerging internationally. (The price of the commodity crude itself plays a significant role in the calculating the potential cost-effectiveness of this equation).

It is not uncommon in this ever-outward-expanding universe of international commerce to find a hybridization of transportation that makes it difficult to decide where one mode of transportation lets off, and where another begins. This hybridization allows for the:

1) transportation of cargo on containerized seafaring vessels by means of what is today know as an “intermodal container”

2) expansion of an industry based primarily on the transfer of freight between differing modes of transportation

3) the transportation of containerized freight across land after travel overseas by means of either truck, rail, or both

4) the delivery of the freight to regional distribution centers by means of conventional trucking

5) the industry of warehousing, sorting, processing, and repackaging cargo for distribution to localized facilities

6) the transporting of freight to its final destination, most typically by means of conventional trucking.

7) Rounding out the list is the use of one means of transportation to transport another, whether by land or by sea.

This is nothing new. The now-defunct Seatrain Lines is often credited with the introduction of the standard international intermodal container, most commonly 8 feet high, 8 feet wide, and 40 feet long. In 1929, Seatrain Lines began the innovative practice of hauling rail cars by ship from the port of New York to Havana, Cuba. Their two ships, Seatrain New York and Seatrain Havana were each capable of carrying 100 fully loaded railcars on their four decks. As long ago as 1932, an article in Popular Mechanics referred to Seatrain as having “the most unusual ship afloat.”

In a world that is populated by hybrid forms of transportation, what may serve as a fair measure of “the transports” in this day and age? Enter, stage right, the S&P Transportation Select Industry Index, one of a growing number of specialty indices. As Standard and Poors explains: “S&P Select Industry Indices are designed to measure the performance of narrow Global Industry Classification Standard (GICS®) sub-industries, the most detailed level of industry definition. The index series currently includes 25 indices spanning nine different GICS sectors. Constituent stocks are members of the S&P Total Market Index (S&P TMI) which includes all common equities listed on the NYSE and the NASDAQ U.S. Exchanges.”

A relatively new (inception date 1/26/11) exchange traded fund also seeks to answer the question. Enter stage left XTN, the SPDR S&P Transportation ETF. Before expenses, it “seeks to closely match the returns and characteristics of the S&P Transportation Select Industry Index.” While there are some other transportation related ETFs available, this one serves as a fair proxy for the index.

There is one minor problem, and that relates to its utility as a trading vehicle. While the ETF arguably should bear broader acceptance, it is thinly traded. As of market close today (June 21, 2012) it had traded a mere 934 shares, with volume traded since the beginning of the week of only 2,704 shares. Not quite what you'd call a liquid investment. And, if history is any indication, thinly-traded ETFs tend to have limited lifespans.

As Ron Rowland explains in a recent commentary in his ongoing series ETF Deathwatch: “The number of names on ETF Deathwatch climbs by a dozen for June with 19 new additions and seven deletions. The new count stands at 336, consisting of 237 ETFs and 99 ETNs. This is an astonishing 127% increase from the 148 names of a year ago. Excluded from eligibility are 129 of the 1,465 listings (as of May 31) because they were launched in the prior six months and are given a grace period to gain traction with investors. That means just 1,336 ETFs and ETNs are currently eligible, and more than a quarter (25.1%) of them are now on ETF Deathwatch.”

Hands down, the Wikipedia definition beats the Investopedia definition of Beta: “In finance, the Beta (ß) of a stock or portfolio is a number describing the volatility of an asset in relation to the volatility of the benchmark that said asset is being compared to. This benchmark is generally the overall financial market and is often estimated via the use of representative indices, such as the S&P 500.”

This presents another potential difficulty for the trader. With the ever-increasing popularity of exchange traded funds (complete with double or triple leverage, both long and short versions of which now exist) it has been observed that at least some individual stocks have developed a tendency to follow the industry-specific ETF of which they themselves are a component. This raises the question of which is the proverbial chicken, and which is the proverbial egg? More to the point, it raises the question of precisely which benchmark to use for a given security.

I have to wonder what Gann would think of today's ETFs as compared to the older and better-established benchmarks. And, what would he think of being able to trade those benchmarks, albeit by proxy through a corresponding ETF, today.

Just think about all of the contributions to trading by the likes of Dow and Gann that were made without the benefits of computers. As Colby explains it: “Considering its absence of evolutionary change, it is all the more remarkable that the Dow Theory has survived the test of time over the past turbulent century of unprecedented events, which included two world wars, a world-wide economic depression, and mind boggling triumphs of science and technology unimaginable in Charles H. Dow's day. Consider too that Dow created from scratch a predictive stock market barometer over a period of just a few years, with only a small quantity of primitive data and with no computer. If Charles H. Dow and his successors, S. A. Nelson, William P. Hamilton, and Robert Rhea, were alive today, they might extend their pioneering work with the help of vastly more data and power to analyze that data than they ever could have imagined.”

Why Colby neglected to mention Gann is anyone's best guess. His writings are far more accessible than are his charts, and they bear as much relevance to trading in the modern era as they did back in his.

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