Part II : Asset Building Through Equity
CHAPTER 10: DOW THEORY
Chance favours the prepared mind.
LOUIS PASTEUR
INTRODUCTION:
Charles Dow is commonly referred as the granddaddy of technical analysis, Dow Theory was formulated from a series of Wall Street Journal editorials authored by Charles H. Dow from 1900 until the time of his death in 1902. These editorials reflected Dow’s beliefs on how the stock market behaved and how the market could be used to measure the health of the business environment.
Due to his death, Dow never published his complete theory on the markets, but several followers and associates have published works that have expanded on those editorials. Some of the most important contributions to Dow Theory were William P. Hamilton's "The Stock Market Barometer" (1922), Robert Rhea's "The Dow Theory" (1932), E. George Schaefer's "How I Helped More Than 10,000 Investors to Profit in Stocks" (1960) and Richard Russell's "The Dow Theory Today" (1961).
Charles Dow, however, never wrote a book and never used the term “Dow Theory”. It was A.J.Nelson, a close friend of Charles Dow who formalised the theory for economic forecasting and dubbed it the Dow Theory. As on date, whatever is generally being accepted as technical analysis has its roots in the Dow Theory.
Dow first used his theory to create the Dow Jones Industrial Index in 1884 and the Dow Jones Rail Index (now Transportation Index), which were originally compiled by Dow for The Wall Street Journal. Dow created these indexes because he felt they were an accurate reflection of the business conditions within the economy as they covered two major economic segments: industrial and rail (transportation). While these indices have changed over the last 100 years, the theory still applies to current market indices.
Dow, who developed this theory to explain the movement of the indices, relied exclusively on closing prices and did not use the high-low-close (bar charts). However, the theory is also applicable to individual scrips. Also, he made certain assumption, which has been referred to as the hypothesis of the theory.
Much of what we know today as technical analysis has its roots in Dow’s work. For this reason, all traders using technical analysis should get to know the six basic tenets of Dow Theory. Let’s explore them.
THE CONCEPT:
1. Markets have three trends
2. Trends have three phases
3. The stock market discounts all news
4. Stock market averages must confirm each other
5. Trends are confirmed by volume
6. Trends exist until definitive signals prove that they have ended
1. Markets have three Trends
The markets can be divided into three trends:
1. Primary Trend
2. Secondary Trend
3. Tertiary Trend / Minor Trend
The Primary Trend can be a rising or falling market. The primary trend should last for more than a year and can endure for many years.
Secondary Trends can be found within the primary trend. They represent correction phases. Their duration is usually three weeks to three months. These reactions are often 1/3 to 2/3 of the secondary movement of the previous trends.
Short-term movements are Tertiary Trends, or minor trends or daily fluctuations, a period that can persist upto three weeks. Secondary trends consist of a series of minor trends.
According the Dow Theory, short-term price movements can be influenced by higher order volumes. However, the primary and secondary trends are not influenced by the short-term price movements. For this reason, Tertiary Trends are unimportant and do not need special attention.
The minor trend or daily fluctuations are quite deceptive and tend to correct the overbought and oversold conditions that are created by the secondary reactions. It would be best to ignore this type of daily fluctuations and concentrate on the intermediate and the main trend of the market. This minor trend tends to retrace the rise or fall during the intermediate trend by 33-66%.
Bullish Move
According to Dow, if the indices exhibit the formation of higher bottoms and higher tops, the trend would be said to be bullish and as long as this phenomenon of higher bottom and higher top continues, the trend continues to rise.
Bearish Move
If on the other hand, the indices start to exhibit the formation of lower tops and lower bottoms, the trend would be said to have turned bearish. Also, as long as the indices register lower tops and lower bottoms, the trend continues to be bearish.
Action Required
A buy and hold approach should be adopted in a rising or bullish market and a sell or move out approach should be adopted in the bear or falling markets.
2. Primary Trends have three Phases
The primary trend can be divided into three phases:
1. Accumulation Phase
In the first phase (Accumulation Phase) shares will be bought by informed investors who expect an economic recovery and anticipate a long-term growth. During this phase, most of the “other investors” stand opposed to equities.
In the accumulation phase, investors begin to build up stocks.
2. Participation Phase
The Participation Phase is characterized by rising corporate profits and better economic conditions. More and more Investors buy shares.
3. Distribution Phase
In the third phase, the Distribution Phase, shares are sold. The distribution phase is marked by record profits of the companies. The masses feel confident to participate in equities. Investors always buy more shares and believe that the prices keep rising.
In this phase, informed investors sell, because they expect an economic slowdown.
THREE TYPES OF MARKET MOVEMENTS
Markets fluctuate in more than one time frame at the same time:
Dow compared the three types of market fluctuations/movements to the tide, waves and ripples of the sea. If one were to stand on the sea and observe the tide, one would notice that during high tide, each successive wave makes further inroads onto the shore and the net effect would be a gain on the sea-shore. Now, if the tide were to turn, one would notice that each wave moves further into the sea and the net result of the waves (forward and backward) would be a loss on the sea-shore.
The market has three well defined movements which fit into each other.
1. (Ripple).
The first is the daily variation due to local causes and the balance of buying and selling at that particular time.
2. (Wave).
The secondary movement covers a period ranging from days to weeks, averaging probably between six to eight weeks
3. (Tide).
The third move is the great swing covering anything from months to years, averaging between 6 to 48 months.
NOTE:
Primary Trends
Bull markets are broad upward movements of the market that may last several years, interrupted by secondary reactions.
Bear markets are long declines interrupted by secondary rallies.
These movements are referred to as the primary trend.
SECONDARY MOVEMENTS
Secondary movements normally retrace one third to two thirds of the primary trend.
POINTS TO PONDER
Daily fluctuations
Daily fluctuations are important for short-term trading, but are unimportant in analysis of broad market
Large Corrections
A large correction occurs when price falls below the previous low (during a bull trend) or where price rises above the previous high (in a bear trend).
CHANGE OF TREND
Only accept large corrections as trend changes in the primary trend:
A bull trend starts when price rallies above the previous high.
A bull trend ends when price declines below the previous low.
A bear trend starts at the end of a bull trend (and vice versa).
Hypothesis of Dow Theory:
1. The first hypothesis states that ‘the primary trend cannot be manipulated’. The primary trend has been defined as a broad upward or downward movement that is commonly known as the bull or bear market and lasts for over a year or a number of years. No single individual or group of individuals can exert influence on the major trend of the market. Manipulation is, however, possible in the day-to-day movement and to a lesser degree, on the intermediate term movement. Here, the intermediate term movement has been defined as the price movement that lasts from over two to three weeks on an equal number of months.
2. The second hypothesis states that the ‘averages discount everything’. This is one of the basic assumptions on which technical analysis rests. As per this hypothesis the market discounts the hopes, fears, muscle power, insider information, et al. In fact, according to Dow, natural calamities like earthquakes, fires, etc also get quickly discounted in the market price.
3. As per the third hypothesis, ‘the theory is not infallible’. It is not a tool to beat the market, but a way to understand it better. Also, Dow does not give the time frame or the likely price targets; he just talks of the broad upward and downward movement, which according to him is the most important message for the investors.
3. The Stock Market is discounting all Informations
Each share price reflects all informations that are known about an investment. As soon as new informations are available, the price immediately reacts to this news.
Equity indices reflect all the informations which are known to all stocks. They represent an aggregated sum of all information.
In this respect the ‘Dow Theory agrees with the hypothesis of market efficiency’.
4. Stock Market Indices must confirm each other
During the period when Charles Dow gained knowledge, the U.S. was a growing industrial nation. Urban centres and production centres were far apart. Factories had to transport their goods to urban centers, typically by railroad. The first Dow-Indices were an Industry Index and Transport Index.
According to Charles Dow, a rising Industry Index was not sustainable as long as the Transport Index did not also rise. The idea behind it was the following: If the producers reported rising profits, then they have produced more. If they produced more, they had transported their goods to the customers. Consequently, an investor has to notice the Industrial Index as well as the Transport Index. Both Indices should be in the same direction. A divergence is to be evaluated as a warning sign.
5. Trends are confirmed by the Volume
Dow laid great emphasis on volume. According to him, volume should expand along the main trend. This means that if the main trend is bullish, the volume should increase with the rise in prices and fall during the intermediate reactions. If one were to find that the volume falls during the rise and rises during the reactions, then the bull market or the main bullish trend becomes suspect.
6. Trends exist until clear signals signify an end
Recent market developments may move in the opposite direction of the Primary Trend. With the help of trend lines and indicators, an investor can identify if a price movement is a short-term movement or the beginning of a new primary trend.
Dow Theory: Current Relevance
There is little doubt that Dow Theory is of major importance in the history of technical analysis. Many of its tenets and ideas are the basis of much of what we know today. Aspects of Dow Theory are also incorporated into other theories, such as Elliott Wave theory.
One of the bigger problems with the theory is that followers can miss out on large gains due to the conservative nature of a trend-reversal signal. A signal is confirmed when there is an end to successive highs (uptrend) or lows (downtrend). However, what often happens is that by the time the market has shown a clear sign of reversal, the market has already generated a large gain or loss.
Also of importance in Dow Theory is the idea of emotions in the marketplace, which remains a characteristic of market trends. Charles Dow and Dow Theory helped investors improve their understanding of the markets so that they could make better investments and achieve investment success.
Recommended Reading:
Technical Analysis of Stock Trends
By Robert D. Edwards, John Magee
Dow Theory And The Great Depression
"On the late Charles H. Dow's well-known method of reading the stock market movement from the Dow Jones Averages, the twenty railroad stocks on Wednesday October 23 confirmed a bearish indication given by the industrials two days before. Together the averages gave the signal for a bear market in stocks after a major bull market with the unprecedented duration of almost six years..."
With his words, William Peter Hamilton (1867-1929), had written the Obituary for the most speculative period in American history, the end signaled by a Dow Theory confirmation.
Conclusion
The Dow Theory is concerned with just the trend of the market and has no forecasting value as regards the duration or the likely price targets for the peak or bottom of the bull and bear market
Even today, the theory finds application in the stock market. In fact, this is one theory that has stood the test of time rather remarkably.
Dow Theory represents the beginning of technical analysis. Understanding this theory should lead you to a better understanding of technical analysis and of an analyst's view of how markets work.
Dr.Felisleo
23.1.2011
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