Charles Dow was a financial journalist at the end of the nineteenth century who truly revolutionised stock market investing. At that time, bonds were the favored investment vehicle, and there were no stock market indexes, no daily publications of price movements, and inconsistent release of company financial statements.
In 1882 along with partners Edward Jones and Charles Bergstresser, Dow founded the Customers Afternoon Letter, which would evolve into the Wall Street Journal. The letter published consolidated stock tables and even the quarterly and financial information some companies were reluctant to release.
Some feel the publication of this letter led to the birth of the retail investor. Prior to that time, many companies only released financial information to investment insiders. By publishing this information, Dow gave the retail investor the opportunity to study the same information the insiders had.
Dow and his partners were also the first to see the need to establish an index that would serve as a barometer of stock market investing as a whole. They gave birth to the Dow-Jones Index that evolved into today’s Dow Jones Industrial Average (DJIA).
In his Customer Afternoon Letter and later the Wall Street Journal Dow wrote a series of editorials outlining his observations on the stock market, focusing much on his belief that the market moved in trends and these trends were related to certain kinds of business activity.
For example, in Dow’s time the United States was in the midst of a massive industrial expansion. Manufacturing centers were spread across the country and finished goods needed to be transported to population centers. Railroads were the primary means of transport. Dow theorised that economic growth in manufacturing activity would lead to growth in rail activity. What’s more, an increase in railroad activity could foreshadow a coming increase in the manufacturing sector.
This observation led to a reshuffling of the original Dow Jones Index into separate indexes – the Dow Jones Industrial Average and the Dow Jones Transportation Index.
In good times, both railroads and manufacturing move upward. However, a reversal in the trend of one is an indicator of a coming downtrend in the other.
After his death in 1902, a colleague – S.A. Nelson – published The ABC of Stock Speculation in which he organised Dow’s observations into what Nelson called Dow Theory.
Today, many investors credit Dow as the father of technical analysis. His observation as outlined in Dow Theory included ideas we take for granted today.
First, he observed that markets move in three different trends – primary, intermediate, and minor. These trends can indicate either a bull market or a bear market. In a primary bull market, there are three phases – accumulation, participation, and excess. In a primary bull market, the three phases are distribution, public participation, and panic or sell-off.
Dow also observed that trading volume was the key to confirming a trend and identifying a trend reversal. Not all changes in direction represent true reversals of the trend.
Perhaps Dow’s most important observation was that the market quickly discounts information. Once company news becomes public, the market will rapidly incorporate the news into the price. This observation was key to the later work on the efficient market hypothesis.
Today, some investors see Dow Theory as something of ancient relic. However, words that pepper many discussions of the markets like trend, accumulation, peak, trough, reversal, uptrend, and downtrend, all are a result of Dow’s study of market activity.
Dow’s observation of the interrelationship between price movements in share markets and certain kinds of economic activity has withstood the test of time. A contemporary indicator that some investors use in the same way Dow looked to the early railroad index can be had in the Baltic Dry Index (BDI.)
The Baltic Dry Index is published daily in London and it measures worldwide shipping prices for raw materials and dry bulk goods. Intelligent investors see this index as perhaps the most reliable predictor of global demand available.
For one thing, you cannot trade this index, making it free of speculative influence. The numbers published are real price quotes and updated daily. Almost all macroeconomic indicators – unemployment, consumer sentiment, Gross Domestic Product, and inflation – include estimates that are frequently later revised upward or downward. Another significant downside to these indicators is that they are lagging, often months old.
A rising BDI is an indication of increased global demand for the raw materials needed for industrial activity of all kinds. Similarly, a drop in the index indicates decreasing global demand.
If you are a believer in the BDI, you already know the predictive value of this index appears not be what it used to be. In the past year, while global economies have begun to recover and markets have rallied all over the world, the BDI has dropped about 60% from May 2010 to May 2011.
Some experts cite slowing Chinese demand, the recent cyclonic activity in Australia, and an increase in the supply of shipping vessels as reasons for the disparity.
Others question whether genuine global demand is fuelling the recovery. They tell us to watch the real price of commodities. Once the speculative money has fled commodities, a continuing decline in commodity prices will signal a drop in world trade.
Whatever happens, we have Charles Dow to thank for introducing the idea of using economic indicators to predict price movement in share markets.