Worried about the bear? Check this theory

Rushed selling at a downturn leads to loss

Panic is a bad investment strategy. Yet that is exactly how many investors reacted earlier this month when the stock market dropped precipitously. They indiscriminately dumped their stocks at whatever prices they could get.

Odds are good that they will end up regretting their behavior.

I say that not just because the stock market has recovered some. It is still possible that a bear market did begin from the late-January market highs. But since most scary drops do not lead to major bear markets, it’s virtually assured that — over the long term — selling after every unnerving decline will lead to more losses than gains.

If you’re not a long-term buy-andhold investor, therefore, you need an investment system that keeps you from panicking every time the market starts heading south. The Dow Theory is the oldest and perhaps the most popular of such systems. Like any good investment discipline, it provides you with preset rules that try to differentiate between less serious bouts of market volatility and the beginnings of devastating bear markets.

Currently, followers of the Dow Theory are giving the stock market the benefit of the doubt.

The Dow Theory was created in the early part of the last century by William Peter Hamilton, then editor of The

Wall Street Journal. He introduced the strategy in a series of editorials until his death in 1929. He advised readers to focus not on the initial pullback from market highs but on the market’s attempt to recover. A bear market signal would be triggered if that recovery were so weak that either the Dow industrials or the Dow transports would fail to close above their previous highs, and then both Dow averages would break below their lows hit in the initial pullback.

Here’s how that applies to the current market: If in coming weeks the Dow industrials surpass their Jan. 26 closing high of 26,616.71 and the Dow transports close above their Jan. 12 record finish of 11,373.38, then the Dow Theory would consider the bull market alive and well.

By contrast, a bear market signal would be triggered if either the Dow industrials or transports couldn’t beat their January highs, and both close below their early February lows — 23,860.46 in the case of the industrials and 10,136.61 for the transports.

Until then, Dow Theorists wait, letting the market tells its story. And one of the key tenets of Hamilton’s approach is that the market’s major trend is presumed to remain in force until formally reversed.

That’s why the Dow Theory currently is giving the bull market the benefit of the doubt.

Note carefully that the Dow Theory isn’t designed to catch the exact tops and bottoms of bull and bear markets. By requiring a decline from market highs to prove itself before a bear market is declared, for example, the strategy is guaranteed to suffer losses at the beginning of a bear market. The same goes in reverse when a bear market gives way to a new bull market.

But there never has been a market timing system that consistently catches the exact day of bull market tops and bear market bottoms, and there never will be.

It is still possible that a bear market did begin from the late-January market highs. But selling after every unnerving decline will lead to more losses than gains.