The Most Time-Tested Stock Market Indicator

“Times may change, but the human emotions of fear and greed remain the same.” – Wall Street saying

Today, I’d like to tell you about Dow Theory — one of the most remarkable stock-market indicators you’ll ever find. This indicator is both amazingly accurate and easy to follow. And because it usually signals only about once every year-and-a-half, you don’t have to watch it like a hawk. Here are just a few reasons why you should pay attention to what it has to say:

* When Dow Theory says we’re in a bull market, stocks rise by an average of 35%.

* Dow Theory has made only seven incorrect bull-market calls over that entire 100+ years of the Dow Industrials. (Amazing!) And most of those wrong calls were just barely wrong, with the stock market losing an average of 5% on them.

* It’s also smart to pay attention when Dow Theory says stocks are falling. Under these circumstances, it’s best to stay out of the market, as stocks lose an average of 6% when the bear signal is given.

Charles Dow developed Dow Theory through his writings in the Wall Street Journal from the late 1800s until his death in 1902. I’m amazed by two things: (1) how well he put together the pieces of what really matters when it comes to creating a stock market-indicator and (2) how little has changed in 100 years.

In short, Charles Dow was interested in the primary trend in the market. He had developed two market indexes, the Dow Industrials and the Dow Rails (now called the Dow Transports), with the idea that they would be good indicators of business activity. Dow theorized that these two indexes represent production (Industrials) and distribution (Transports) — and that when they “confirm” each other (meaning that they are in agreement), the primary trend in the market is clear.

Recently — and I’m sure this comes as no surprise to you — the Dow Industrials and the Dow Transports have confirmed that we are in a primary bear market. Of course, just because this particular indicator tells us we’re in a bear market, that doesn’t mean there isn’t money to be made. It does mean, however, that we are in a period in which, historically, stocks have lost an average of 6%. (And 100+ years of history is tough to argue with.)

I point this out not to offer conflicting information or to dampen your mood about the stock market. I point it out because in order to become a wiser, more successful investor, it’s important to know which indicators are useful and what those indicators are saying now.

Dow Theory is the most time-tested stock-market indicator around. The knock against it is that it is slow to react. Basically, it makes doubly sure before it issues a “buy” or “sell.” That being said, the recent confirmation of the bear market by Dow Theory is a negative for the markets. Bet against it at your own peril.