Dow Jones, Shiller And Momentum Approaches Compared

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We are looking at a variety of trigger mechanisms to signal when to make a change in your portfolio.

1. Dow Theory
2. Shiller's CAPE
3. Momentum Based Asset Allocation

The Dow Theory -- the grand-daddy of all portfolio strategies can be compared with more modern approaches. We will look at Shiller, a long term but newer approach and then modern portfolio theory which is based on asset allocation.

The Dow Theory is one of the most venerable strategies. It uses the price trends of the Dow Jones Industrial index (^DJI) and the Dow Jones Transportation Index (^DJT) to decide whether to invest in the stock market.

The Dow Theory has been around for almost 100 years, yet even in today's volatile and technology-driven markets, the basic components of Dow theory still remain valid. Developed by Charles Dow, refined by William Hamilton and articulated by Robert Rhea, the Dow Theory addresses not only technical analysis and price action, but also market philosophy. Many of the ideas and comments put forth by Dow and Hamilton became axioms of Wall Street.

Today, there are a variety of strategies.

There are multiple interpretations of the original Dow Theory. This strategy represents a typical version: all the buy and sell signals are confirmed by both the Dow Jones Industrial Average and Dow Jones Transportation Average.

The Dow Jones Transportation Average is used to triangulate the Dow Jones Industrial Average to ensure that an upward or downward trend is not just a localized phenomenon.

The buy signal

• A primary low is established

• A secondary bounce

• A pullback of around 3% but above previous lows

• Both averages hold above the prior lows

• Both averages exceed the secondary bounce

The sell signal

• A primary high is established

• A secondary drop

• A rally of over 3% but falls short of the previous high

• A drop of both averages below the previous drop

The funds in the portfolio are (ETF alternatives):

• Wilshire 5000 total return index ^DWC (VTI, SPY, IWM)
  

• Cash (BND)
  

Yale Professor Robert Shiller devised and maintained a ‘Cyclically Adjusted Price Earning' ratio (CAPE10) as an alternative to the popular PE ratio to value the US stock market. CAPE10 is defined as the ratio of price to the average of last 10 year trailing S&P 500 annual earnings. We capture this strategy called Shiller Cyclically Adjusted PE 10 Stock Market Timing Strategy. This strategy characterizes the stock market valuation into the following five categories based on the ratio of the current CAPE10 to the long term average CAPE10:

• Significantly Overvalued (SO): such as if the ratio >= 150%
• Modestly Overvalued (MO): such as if   117% <=  ratio < 150%
• Fairly Valued (FV): such as if 83% <= ratio < 117%
• Modestly Undervalued (MU): such as if 67% <= ratio < 83%
• Significantly Undervalued (SU): such as if ratio < 67%

We implement a simple strategy that makes a switch to cash once the market is significantly overvalued and back to equities when the market is modestly undervalued.

The funds in the portfolio are (ETF alternatives):

• Wilshire 5000 total return index ^DWC (VTI, SPY, IWM)
  

• Cash (BND)
  

Finally we take the tactical asset allocation which uses a 200 day rolling average.

Results:

Click here for the interactive graph.

Historical Returns for Dow Theory, Shiller and 6SIB TAA

The Dow Theory has not been effective in the last ten years given the prevailing market conditions. It is possible that a different investment portfolio would perform better but given that Shiller is using similar funds, Shiller appears to be a better choice.