The Dow Theory

The Dow Theory: Applying SR to Individual Stocks

The application of SR to specific stock price trends has its genesis in many of the theories first suggested by Charles Dow. Among these theories is that of confirmation, the independent signals derived from one indicator that support the same conclusions previously found in another. All technical analysts should recognize the importance of confirmation as they study SR and other chart patterns.

Formulated by Charles Dow in the late 19th century, what later became known as the "Dow Theory" was originally intended to be used as a forecasting system to anticipate economic conditions, not as a trading system for the stock market. Dow believed that the market was the best prognosticator of the economic future long before the days when such forecasting became dominated by market analysts and fund managers. Dow saw the study of market averages as a viable method for forecasting the direction of the economy. Today, with the Dow Theory used almost exclusively to forecast market-wide trends, there is little economic application other than to use the Dow Jones Industrial Averages (DJIA) to explain other economic changes. However, the DJIA is more often cited today as reacting to economic conditions, rather than anticipating them. So Dow's original theory has been modified to serve different needs, those of the technical analyst. The study of SR as part of the Dow Theory is worthwhile in the sense that these ideas can be applied to individual stocks where they are more useful. Overall market trends are of less interest to the technician, whose time is better spent trying to anticipate price and trend changes in individual stocks.

As a model for studying price movement, the Dow Theory sets down specific "rules" or observations to anticipate future changes. Dow and his partner Edward C. Jones (the two are better known today as "Dow Jones") came up with the idea of using market indexes to track broader trends. Their ideas were published in the financial newspaper that was first printed on July 8, 1889, called The Wall Street Journal. (The paper was originally called Customer's Afternoon Letter and was in publication since 1882.)

The Dow Theory itself was not formulated until after Dow's death in 1902. Samuel Nelson identified the attributes of the modern theory in his book, The ABCs of Stock Speculation.

The Dow Theory originally had one 12-stock market index, later expanded to two; these were based on industrials and transportation stocks (originally called "rails" because only railroad companies were included). These are referred to today as the Dow Jones Industrial Average and the Dow Jones Transportation Average. A third index, the Dow Jones Utilities Average, was added later on. Dow made extensive use of confirmation. As a basic premise, he determined that in order for a primary trend to exist, both indexes had to confirm the factors required: specifically, in order to call a trend a primary trend, both needed to break through the support or resistance level. If the two averages diverged, that meant the indicator was a false one, because it failed the confirmation test.

The Dow Theory views the three averages as barometers of likely future market activity. If the market climate is positive (bullish) then trends in prices should be upward. If the mood of the market is pessimistic, that will be reflected in weakening stock prices, and a negative climate (bearish) is likely to pull prices downward. We must remember that, although Dow's original essays discussed the use of market trends to forecast business activity, in modern application it works in the opposite direction: stock price trends among market leaders are used to predict market movement. Thus, weakening economic factors affecting a company's sales and profits are later reflected in lowering stock prices.

The averages are studied in search of confirming or contradicting signals. The Dow Theory is premised on the idea that trading trends—or overall support

Figure 2-1

and resistance—can be anticipated by way of confirmation. Figure 2-1 shows an example of a late confirmation of the trend by the DJIA versus the DJT. At point A the Dow sells off, breaking support levels along the way, but the Transportations continues to trend higher. Then at B, the Dow confirms the up trend again by breaking resistance.

Figure 2-2 is an example of the weekly closing chart for the DJIA and the DJTA for 1997-98. At point A, the DJIA trades down, breaking the previous support points. Next, the DJIA makes a peak followed by a lower peak (trend line C), and closes below support at point D. However, the DJTA diverges by making a new high, but holds support. Next, at point E, both averages are once again in gear, confirming the up trend.

When one average breaks through resistance and the other does not, the "failure to confirm" is a

Figure 2-2

warning, also called divergence. This should not be construed as a market reversal, but as a trend reversal when both averages break support levels and have falling resistance levels (Figure 2-3).

Figure 2-3

The divergence between the two averages often precedes confirmation of a newly established down trend. Figure 2-4 illustrates how the divergence indicates trading range price action or a trend reversal. Trend line A is upwards on the Dow, while it is downwards on the Transportations, a typical divergence pattern. Trend line B is up on the Transportations and down for the Dow. Finally, trend line C for the Dow is horizontal, showing strong resistance at 11,250 while trend line C for the Transportations is down. This divergence series ultimately led to a major decline for both indexes. Still, the trading range encompassed approximately two years' trading range activity with multiple divergences before the breakdown occurred. Trading ranges are called lines and can last for a considerable period. During these periods, the astute technician may adopt a more conservative trading approach, as the trend moves sideways until a confirmed new trend begins.

Figure 2-4