Dow & His Averages

By Kenneth Robson on July 9, 2012 • ( 1 )

Charles Dow honed his journalistic skills from the age of 21 as a reporter for the Springfield Daily Republican. It wasn’t until he started working for the Providence Journal in 1877 that he started writing business stories.

It was a time of distinct oscillations between bullish and bearish periods, determined by the fortunes of railroad stocks in a period of rapid expansion of the rail network. He found it helpful to use various market averages to decide whether it was the bulls or bears that held sway. The strategy then was to hold value stocks throughout the bull markets.

Charles Dow created his first index of 11 mostly railroad stocks in 1884. The stocks he chose were: Chicago & North Western; Union Pacific; Delaware, Lackawanna & Western; Missouri Pacific; Lake Shore; Louisville & Nashville: New York Central; Pacific Mail; St. Paul; Western Union; Northern Pacific preferred.

He adjusted the index from time to time substituting Industrial for Railroad stocks. This culminated in an Industrial Average launched May 26 1896.The stocks he chose were: American Cotton Oil; American Sugar; American Tobacco; Chicago Gas; Distilling & Cattle Feeding; Laclede Gas; National Lead; North American; Tenn. Coal & Iron: US Leather preferred; and US Rubber. Initially only these 12 stocks were included in the Dow Jones Industrial Average, but it was expanded to 20 stocks in 1916 and to 30 stocks in 1928.

In October 1896 he introduced a second leading index, composed of just railroad stocks; initially called the Dow Jones Railroad index, the name was changed in 1970 to the Dow Jones Transportation Average.

Dow considered that to be sure of the state of the market both averages should be in agreement. This is the third of the often quoted three tenets of Dow Theory. I.e. Both averages must confirm.

The first tenet of Dow Theory as enunciated by the so called “Dow Theorists” who followed him states: The averages discount everything. This statement has been construed as saying that all relevant information about a stock is factored into the share price by the market. It is price action only that is relevant.

I haven’t been able to find this exact statement in Dow’s articles. Furthermore knowing how much importance he attached to the underlying quality of stocks, I question whether this is what he really meant.

The column that seems to most accurately state his opinion is entitled Values and Prices published Feb 28, 1902, and reproduced in “Dow Theory Unplugged”. His statement is “This is that the stock market discounts expected changes in conditions”. My understanding of this article is as follows:

Dow discussed price divergences from estimated value. He pointed out that stock prices should not be fixed on past earnings. Value increases when increasing surplus earnings outstrips rises in the share prices. While stock prices tend to move in concert, individual companies may well outperform or underperform, creating buying or selling opportunities.

He pointed out that “It is probable that stock prices will fall before changes in earnings become extremely pronounced”. Market falls in price are often precipitous and extreme before the value of the company based on continuing earnings falls.

Australia’s Macquarie Dictionary lists twelve contexts for the use of the word discount. In my opinion the most appropriate meaning for this word in the context used is: “to take (an event etc) into account in advance, especially with loss of value, effectiveness, etc.”

The market price anticipates the likelihood of further earnings decline. If this does not eventuate, in time the market will recognize it; the share price should then rebound.

Markets over and under react all the time; price is not an accurate indicator of value. It is futile to argue with the market; use it if possible to your own advantage!