Introduction: Dow Theory

INTRODUCTION

Charles Dow and his partner Edward Jones founded Dow Jones & Company in 1882. Most technicians and students of the markets concur that much of what we call technical analysis today has its origins in theories first proposed by Dow around the turn of the century. Dow published his ideas in a series of editorials he wrote for the Wall Street Journal. Most technicians today recognize and assimilate Dow's basic ideas, whether or not they recognize the source. Dow Theory still forms the cornerstone of the study of technical analysis, even in the face of today's sophisticated com­puter technology, and the proliferation of newer and supposedly better technical indicators.

On July 3,1884, Dow published the first stock market aver­age composed of the closing prices of eleven stocks: nine railroad companies and two manufacturing firms. Dow felt that these eleven stocks provided a good indication of the economic health of the country. In 1897, Dow determined that two separate indices would better represent that health, and created a 12 stock industrial index and a 20 stock rail index. By 1928 the industrial index had grown to include 30 stocks, the number at which it stands today. The editors of The Wall Street Journal have updated the list numerous times in the ensuing years, adding a utility index in 1929. In 1984, the year that marked the one hundredth anniversary of Dow's first publication, the Market Technicians Association presented a Gorham-silver bowl to Dow Jones & Co. According to the MTA, the award recognized "the lasting contri­bution that Charles Dow made to the field of investment analy­sis. His index, the forerunner of what today is regarded as the leading barometer of stock market activity, remains a vital tool for market technicians 80 years after his death."

Unfortunately for us, Dow never wrote a book on his the­ory. Instead, he set down his ideas of stock market behavior in a series of editorials that The Wall Street Journal published around the turn of the century. In 1903, the year after Dow's death, S.A. Nelson compiled these essays into a book entitled The ABC of Stock Speculation. In that work, Nelson first coined the term "Dow's Theory." Richard Russell, who wrote the introduction to a 1978 reprint, compared Dow's contribution to stock market theo­ry with Freud’s contribution to psychiatry. In 1922, William Peter Hamilton (Dow's associate and successor at the Journal) catego­rized and published Dow's tenets in a book entitled The Stock Market Barometer. Robert Rhea developed the theory even further in the Dow Theory (New York: Barron's), published in 1932.

Dow applied his theoretical work to the stock market aver­ages that he created; namely the Industrials and the Rails. However, most of his analytical ideas apply equally well to all market averages. This chapter will describe the six basic tenets of Dow Theory and will discuss how these ideas fit into a modern study of technical analysis. We will discuss the ramifications of these ideas in the chapters that follow.

BASIC TENETS

1.The Averages Discount Everything.

The sum and tendency of the transactions of the Stock Exchange represent the sum of all Wall Street's knowl­edge of the past, immediate and remote, applied to the discounting of the future. There is no need to add to the averages, as some statisticians do, elaborate compilations of commodity price index numbers, bank clearings, fluc­tuations in exchange, volume of domestic and foreign trades or anything else. Wall Street considers all these things (Hamilton, pp. 40-41).

Sound familiar? The idea that the markets reflect every possible knowable factor that affects overall supply and demand is one of the basic premises of technical theory, as was mentioned in Chapter 1. The theory applies to market averages, as well as it does to individual markets, and even makes allowances for "acts of God." While the markets cannot anticipate events such as earthquakes and various other natural calamities, they quickly discount such occurrences, and almost instantaneously assimilate their affects into the price action.

2.The Market Has Three Trends.

Before discussing how trends behave, we must clarify what Dow considered a trend. Dow defined an uptrend as a situation in which each successive rally closes higher than the previous rally high, and each successive rally low also closes higher than the previous rally low. In other words, an uptrend has a pattern of rising peaks and troughs. The opposite situation, with successively lower peaks and troughs, defines a downtrend. Dow's definition has withstood the test of time and still forms the cornerstone of trend analysis.

Dow believed that the laws of action and reaction apply to the markets just as they do to the physical universe. He wrote, "Records of trading show that in many cases when a stock reach­es top it will have a moderate decline and then go back again to near the highest figures. If after such a move, the price again recedes, it is liable to decline some distance" (Nelson, page 43).

Dow considered a trend to have three parts, primary, sec­ondary, and minor, which he compared to the tide, waves, and rip­ples of the sea. The primary trend represents the tide, the sec­ondary or intermediate trend represents the waves that make up the tide, and the minor trends behave like ripples on the waves.

An observer can determine the direction of the tide by not­ing the highest point on the beach reached by successive waves. If each successive wave reaches further inland than the preceding one, the tide is flowing in. When the high point of each succes­sive wave recedes, the tide has turned out and is ebbing. Unlike actual ocean tides, which last a matter of hours, Dow conceived of market tides as lasting for more than a year, and possibly for several years.

The secondary, or intermediate, trend represents correc­tions in the primary trend and usually lasts three weeks to three months. These intermediate corrections generally retrace between one-third and two-thirds of the previous trend movement and most frequently about half, or 50%, of the previous move.

According to Dow, the minor (or near term) trend usually lasts less than three weeks. This near term trend represents fluc­tuations in the intermediate trend. We will discuss trend concepts in greater detail in Chapter 4, "Basic Concepts of Trends," where you will see that we continue to use the same basic concepts and terminology today.

3. Major Trends Have Three Phases.

Dow focused his attention on primary or major trends, which he felt usually take place in three distinct phases: an accumulation phase, a public participation phase, and a distribution phase. The accumulation phase represents informed buying by the most astute investors. If the previous trend was down, then at this point these astute investors recognize that the market has assimi­lated all the so-called "bad" news. The public participation phase, where most technical trend-followers begin to participate, occurs when prices begin to advance rapidly and business news improves. The distribution phase takes place when newspapers begin to print increasingly bullish stories; when economic news is better than ever; and when speculative volume and public partic­ipation increase. During this last phase the same informed investors who began to "accumulate" near the bear market bot­tom (when no one else wanted to buy) begin to "distribute" before anyone else starts selling.

Students of Elliott Wave Theory will recognize this divi­sion of a major bull market into three distinct phases. R. N. Elliott elaborated upon Rhea's work in Dow Theory, to recognize that a bull market has three major, upward movements. In Chapter 13, "Elliott Wave Theory," we'll show the close similari­ty between Dow's three phases of a bull market and the five wave Elliott sequence.

4.The Averages Must Confirm Each Other.

Dow, in referring to the Industrial and Rail Averages, meant that no important bull or bear market signal could take place unless both averages gave the same signal, thus confirming each other. He felt that both averages must exceed a previous secondary peak to confirm the inception or continuation of a bull market. He did not believe that the signals had to occur simultaneously, but rec­ognized that a shorter length of time between the two signals pro­vided stronger confirmation. When the two averages diverged from one another, Dow assumed that the prior trend was still maintained. (Elliott Wave Theory only requires that signals be generated in a single average.) Chapter 6, "Continuation Patterns," will cover the key concepts of confirmation and diver­gence. (See Figures 2.1 and 2.2.)

5.Volume Must Confirm the Trend.

Dow recognized volume as a secondary but important factor in confirming price signals. Simply stated, volume should expand or increase in the direction of the major trend. In a major uptrend, vol­ume would then increase as prices move higher, and diminish as prices fall. In a downtrend, volume should increase as prices drop and diminish as they rally. Dow considered volume a secondary indicator. He based his actual buy and sell signals entirely on clos­ing prices. In Chapter 7, "Volume and Open Interest," we'll cover the subject of volume and build on Dow's ideas. Today's sophisti­cated volume indicators help determine whether volume is increasing or falling off. Savvy traders then compare this infor­mation to price action to see if the two are confirming each other.

Figure 2.1 A long term view of the Dow Theory at work. For a major bull trend to continue, both the Dow Industrials and the Dow Transports must advance together.

6.A Trend Is Assumed to Be in Effect Until It Gives Definite Signals That It Has Reversed.

This tenet, which we touched upon in Chapter 1, forms much of the foundation of modern trend-following approaches. It relates a physical law to market movement, which states that an object in motion (in this case a trend) tends to continue in motion until some external force causes it to change direction. A number of technical tools are available to traders to assist in the difficult task of spotting reversal signals, including the study of support and resistance levels, price patterns, trendlines, and moving averages. Some indicators can provide even earlier warning signals of loss of momentum. All of that not withstanding, the odds usually favor that the existing trend will continue.

Figure 2.2 Examples of two Dow Theory confirmations. At the start of 1997 (point 1), the Dow Transports confirmed the earlier breakout in the Industrial. The following May (point 2), Dow Industrial confirmed the earlier new high in the Transports.

The most difficult task for a Dow theorist, or any trend-fol­lower for that matter, is being able to distinguish between a normal secondary correction in an existing trend and the first leg of a new trend in the opposite direction. Dow theorists often disagree as to when the market gives an actual reversal signal. Figures 2.3a and 2.3b show how this disagreement manifests itself.

Figures 2.3a and 2.3b illustrate two different market sce­narios. In Figure 2.3a, notice that the rally at point C is lower than the previous peak at A. Price then declines below point B. The presence of these two lower peaks and two lower troughs gives a clear-cut sell signal at the point where the low at B is bro­ken (point S). This reversal pattern is sometimes referred to as a "failure swing."

Figure 2.3a Failure Swing. The failure of the peak at C to overcome A, followed by the violation of the low at B, constitutes a “sell” signal at S.

Figure 2.3b Nonfailure Swing. Notice that C exceeds A before falling below B. Some Dow theorists would see a “sell” signal at S1, while others would need to see a lower high at E before turning bearish at S2.

In Figure 2.3b, the rally top at C is higher than the previous peak at A. Then price declines below point B. Some Dow theorists would not consider the clear violation of support, at SI, to be a bona fide sell signal. They would point out that only lower lows exist in this case, but not lower highs. They would prefer to see a rally to point E which is lower than point C. Then they would look for another new low under point D. To them, S2 would represent the actual sell signal with two lower highs and two lower lows.

The reversal pattern shown in Figure 2.3b is referred to as a "nonfailure swing." A failure swing (shown in Figure 2.3a) is a much weaker pattern than the nonfailure swing in Figure 2.3b. Figures 2.4a and 2.4b show the same scenarios at a market bottom.