The Handbook of Technical Analysis + Test Bank. Lim Mark Andrew

Analysis Explained: The Successful Investor’s Guide to Spotting Investment Trends and Turning Points. 4th ed. New York: McGraw-Hill.

      CHAPTER 2

      Introduction to Dow Theory

LEARNING OBJECTIVES

      After studying this chapter, you should be able to:

      • Understand the basic concepts and assumptions of Dow Theory

      • Apply the concepts of Dow Theory to forecast potential entry and exit points in the market

      • Identify the strengths and weaknesses of applying Dow Theory

      • Explain the importance of price and volume confirmation as a basis for determining potential market action

      • Highlight the current challenges to Dow Theory

      Dow Theory lays the basic foundation for modern day technical analysis. Its premises underpin the very study of market action analysis and have withstood the test of time. In this chapter, we shall be discussing the basic assumptions of Dow Theory and its relevance in today’s markets.

      2.1 ORIGINS AND PROPONENTS OF DOW THEORY

      Charles H. Dow is credited for much of the early work that led to what is known today as Dow Theory. Dow’s successor, William P. Hamilton, carried on developing and organizing much of Dow’s original early writings, which included the Wall Street Journal editorials that were published around the beginning of the twentieth century. Hamilton’s work culminated in his book The Stock Market Barometer. A close acquaintance of Dow’s, S. A. Nelson, published a book about Dow’s work entitled The ABC of Stock Speculation and was the first person to refer to Dow’s concepts and ideas as the “Dow Theory.”

      Robert Rhea, a student of Hamilton, was later responsible for much of the categorizing, refining, and formal codification of Dow’s basic premises, which were laid out in Rhea’s book The Dow Theory. It was Robert Rhea’s work that really developed Dow’s Theory and laid the basic foundation with three important assumptions. The first is that the primary trend is not susceptible to manipulation, although there is a possibility that it could occur over the shorter term. Rhea’s second assumption was that the averages discounted everything and that price is a reflection of all information. Finally Rhea proposed that Dow Theory itself is not perfect and that investing according to its principles will not guarantee profitability. At most, it should be regarded as a set of guidelines for investing.

      Dow published, in 1884, a stock market average of 11 stocks that he later developed into a 12-stock Industrial Index and a 20-stock Railroad Average. Dow wanted to create an index of stocks to better reflect the general action of the markets instead of trying to gauge market behavior via individual stock action, which was at the time fairly erratic and open to manipulation. The index was meant to average out or smooth these erratic price movements. The action of the averages was meant to act as a barometer of the current market environment.

      Since then, the 12-stock Industrial Index has gradually evolved into 30 stocks and is known today as the Dow Jones Industrial Average. The Railroad Average is known as the Dow Jones Transportation Average.

      2.2 BASIC ASSUMPTIONS OF DOW THEORY

      There are six basic tenets of Dow Theory, namely:

      1. The averages discount everything.

      2. The market has three trends.

      3. Primary trends have three phases.

      4. A trend persists until its reversal is indicated.

      5. The averages must confirm one another.

      6. Volume must confirm the trend.

      In addition to the six basic tenets, only closing prices are recognized in Dow Theory.

       The Averages Discount Everything (Pricing in Information)

      It is believed that the markets discount everything, except acts of God. This means that the market is the end result of all participatory action, which represents all information that may be known to the markets. The mechanism by which information is known to the market is that of actual participation via capital injection. Although the market cannot discount unexpected events, that is, acts of God or unknown information, it can absorb, react, and adjust to market shocks fairly rapidly. The pricing of all known information need not be instantaneous or be driven by rational participants. There is also no requirement that all participants always act on all information all of the time, or that they react in the same manner.

Figure 2.1 depicts prices declining before September 11, 2001. Is the market trying to discount information that is not as yet known or is it merely coincidental?

Figure 2.1 Is the Market Discounting Unknown Information?

      Courtesy of Stockcharts.com

Figure 2.2 shows the gold market adjusting very rapidly to information about the same event. The market is attempting to discount all information once the information is made known to it.

Figure 2.2 Gold Adjusting Rapidly to New Information.

      Courtesy of Stockcharts.com

      In short, the market action is the sum of all participatory activity, based on the aggregate of the participants’ beliefs, biases, personal predilections, as well as future expectations. Price is the ultimate reflection and embodiment of everything that is knowable. As such, the technical analysts need not concern themselves with the causes or circumstances giving rise to various market action, but only with the effects of the underlying causes.

       The Market Has Three Trends

      The second assumption of Dow Theory is that the market comprises three trends. Robert Rhea explains, in his book The Dow Theory:

      There are three movements of the averages, all of which may be in progress at one and the same time. The first, and the most important, is the primary trend: the broad upward and downward movements known as bull or bear markets, which may be of several years’ duration. The second, and most deceptive movement, is the secondary reaction: an important decline in a primary bull market or a rally in a primary bear market. The reactions usually last from three weeks to as many months. The third and usually unimportant movement is the daily fluctuation.

      Summarizing, the market is believed to express itself as three distinct trends, namely:

      1. Primary trend (major trend) – lasting from months to years (long term)

      2. Secondary reaction (intermediate trend) – lasting from weeks to months (medium term)

      3. Minor trend – lasting from days to weeks (short term)

See Figure 2.3.

Figure 2.3 All Three Trends in the NYSE Composite Index.

      Courtesy of Stockcharts.com

       (1) The Primary Trend

      The largest trend is by far the primary trend, which is normally expected to last from months to years. Rhea hypothesized that primary trends are not susceptible to manipulation and therefore represent a more reliable barometer for investment decisions. It is sometimes referred to as the tides of the oceans. Although the primary trend usually lasts from months to years, Rhea commented that is it very difficult to forecast the extent or duration of a primary trend.

      There are two types of primary trends, namely:

      1. Primary bull trend (bull market)

      2. Primary bear trend (bear market)

In Dow Theory,