In Defense Of Gradualism


Not everybody was crazy about the hedged advice we provided last week regarding the state of the Dow Theory. 

If a bullish primary trend is presumed intact until proved otherwise, some objected, why not use the Dow Theory’s guidelines to provide a clear up or down verdict? And if there’s so much uncertainty, others questioned, why make such a modest reduction in recommended equity exposure?

Our answer has six parts:

• We’re trying to make money in the stock market, not prove how good we are at predicting or how well the Dow Theory works. If that means sometimes conceding we’re unsure of the primary trend, so be it. The conclusions reached on this page impact our own portfolios and those at affiliated Horizon Investment Services, so getting it right will always take precedence over projecting an aura of confidence.

• We may have hedged regarding the status of the primary trend, but our advice regarding your stock portfolio was crystal clear: Hold about 85% of your portfolio in our recommended stocks, with the remainder in a short-term bond fund. That advice is unchanged, though a breakout or breakdown in the averages could change things quickly. 

• Your editor is not an all-or-nothing market timer. Anybody who uses (or reports) our market-timing advice in an all-or-nothing fashion is doing a disservice to their portfolio (or their readers), since we don’t use the Dow Theory that way. We won’t go to 100% cash even with a clear bear-market signal, and we never recommend shorting the market. No market-timing system is good enough to merit such a binary approach.

• We don’t use the Dow Theory to the exclusion of all other considerations. When assessing whether the stock market is breaking down to significant lows, common sense dictates we consider the action of broader market measures like the S&P 500 Index and advance-decline lines. When determining our stock-market exposure, common sense dictates we consider the market’s valuation and the opportunities available in individual stocks. If that means we’re not Dow Theory purists, so be it. 

• Our gradualist, common-sense approach appears to work. According to our return calculations, which exclude dividends and transaction costs, our Focus List has gained 608.9% (10.2% annualized) since its December 1994 inception on a fully invested basis, versus 349.8% (7.7%) for the S&P 500 Index. Adjusted for our recommended bond-fund exposure, our Focus List has gained 659.6% (10.6%).

According to the independent Hulbert Financial Digest, which includes our bond-fund position in its calculations, the Focus List ranks among a select group of newsletter portfolios that outperformed the stock market for the one, five, 10, and 15 years ended Dec. 31. Since Hulbert began tracking the Focus List in December 1995, it has outperformed the broad Wilshire 5000 Index while exhibiting 7% less monthly volatility than the index. Our more diversified Buy List has also outperformed since December 1995, with 16% less volatility.

• Because of the sharp rally in the averages since Jan. 30, the muddled state of the Dow Theory is likely to clear up considerably in the near term — one way or the other. On the upside, a move above the December all-time highs of 18,053.71 in the Industrials and 9,217.44 in the Transports would reconfirm the bullish primary trend.

On the downside, a breakdown below the respective Jan. 30 closing lows of 17,164.95 and 8,649.32 would represent a fairly clear signal that the primary trend is down. From Jan. 30 to Feb. 5, the Industrials gained 4.2% and the Transports 3.7%. Those gains leave little doubt that the rebounds — and therefore the Jan. 30 closing lows — are significant.

The Jan. 30 close in the Industrials is less than 1% below the Jan. 15 close, while the difference in the Transports is less than 0.1%. So, with likely little to lose by waiting, we’re inclined to wait for a breakdown below the Jan. 30 lows before taking any additional defensive measures.

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