Dow Theory Expended

Dow Theory Expended  
    

1. Introduction

Any attempt to trace the origins of technical analysis would inevitably lead to Dow theory. While more than 100 years old, Dow theory remains the foundation of much of what we know today as 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 the 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).

Dow believed that the stock market as a whole was a reliable measure of overall business conditions within the economy and that by analyzing the overall market, one could accurately gauge those conditions and identify the direction of major market trends and the likely direction of individual stocks.

Dow first used his theory to create the Dow Jones Industrial Index 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 because they covered two major economic segments: industrial and rail (transportation). While these indexes have changed over the last 100 years, the theory still applies to current market indexes.

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.

2. The Market Discounts Everything

The first basic premise of Dow theory suggests that all information - past, current and even future - is discounted into the markets and reflected in the prices of stocks and indexes.

That information includes everything from the emotions of investors to inflation and interest-rate data, along with pending earnings announcements to be made by companies after the close. Based on this tenet, the only information excluded is that which is unknowable, such as a massive earthquake. But even then the risks of such an event are priced into the market.

It's important to note that this is not to suggest that market participants, or even the market itself, are all knowing, with the ability to predict future events. Rather, it means that over any period of time, all factors - those that have happened, are expected to happen and could happen - are priced into the market. As things change, such as market risks, the market adjusts along with the prices, reflecting that new information.

The idea that the market discounts everything is not new to technical traders, as this is a major premise of many of the tools used in this field of study. Accordingly, in technical analysis one need only look at price movements, and not at other factors such as the balance sheet.

Like mainstream technical analysis, Dow theory is mainly focused on price. However, the two differ in that Dow theory is concerned with the movements of the broad markets, rather than specific securities.

For example, a follower of Dow theory will look at the price movement of the major market indexes. Once they have an idea of the prevailing trend in the market, they will make an investment decision. If the prevailing trend is upward, it follows that an investor would buy individual stocks trading at a fair valuation. This is where a broad understanding of the fundamental factors that affect a company can be helpful.

It's important to note that while Dow theory itself is focused on price movements and index trends, implementation can also incorporate elements of fundamental analysis, including value- and fundamental-oriented strategies.

Having said that, Dow theory is much more suited to technical analysis.  

3. The Three-Trend Market

An important part of Dow theory is distinguishing the overall direction of the market. To do this, the theory uses trend analysis.

Before we can get into the specifics of Dow theory trend analysis, we need to understand trends. First, it's important to note that while the market tends to move in a general direction, or trend, it doesn't do so in a straight line. The market will rally up to a high (peak) and then sell off to a low (trough), but will generally move in one direction.

Figure 1: an uptrend

An upward trend is broken up into several rallies, where each rally has a high and a low. For a market to be considered in an uptrend, each peak in the rally must reach a higher level than the previous rally's peak, and each low in the rally must be higher than the previous rally's low.

A downward trend is broken up into several sell-offs, in which each sell-off also has a high and a low. To be considered a downtrend in Dow terms, each new low in the sell-off must be lower than the previous sell-off's low and the peak in the sell-off must be lower then the peak in the previous sell-off.

Figure 2: a downtrend

Now that we understand how Dow theory defines a trend, we can look at the finer points of trend analysis.

Dow theory identifies three trends within the market: primary, secondary and minor. A primary trend is the largest trend lasting for more then a year, while a secondary trend is an intermediate trend that lasts three weeks to three months and is often associated with a movement against the primary trend. Finally, the minor trend often lasts less than three weeks and is associated with the movements in the intermediate trend.

Let us now take a look at each trend.

• Primary Trend

In Dow theory, the primary trend is the major trend of the market, which makes it the most important one to determine. This is because the overriding trend is the one that affects the movements in stock prices. The primary trend will also impact the secondary and minor trends within the market.
Dow determined that a primary trend will generally last between one and three years but could vary in some instances.

Figure 3: an uptrend with corrections

 Regardless of trend length, the primary trend remains in effect until there is a confirmed reversal.
For example, if in an uptrend the price closes below the low of a previously established trough, it could be a sign that the market is headed lower, and not higher.

When reviewing trends, one of the most difficult things to determine is how long the price movement within a primary trend will last before it reverses. The most important aspect is to identify the direction of this trend and to trade with it, and not against it, until the weight of evidence suggests that the primary trend has reversed.

•  Secondary,  or Intermediate, Trend

In Dow theory, a primary trend is the main direction in which the market is moving. Conversely, a secondary trend moves in the opposite direction of the primary trend, or as a correction to the primary trend.

For example, an upward primary trend will be composed of secondary downward trends. This is the movement from a consecutively higher high to a consecutively lower high. In a primary downward trend the secondary trend will be an upward move, or a rally. This is the movement from a consecutively lower low to a consecutively higher low.

Below is an illustration of a secondary trend within a primary uptrend. Notice how the short-term highs (shown by the horizontal lines) fail to create successively higher peaks, suggesting that a short-term downtrend is present. Since the retracement does not fall below the October low, traders would use this to confirm the validity of the correction within a primary uptrend.

Figure 4: a secondary trend w/ a primary uptrend

In general, a secondary, or intermediate, trend typically lasts between three weeks and three months, while the retracement of the secondary trend generally ranges between one-third to two-thirds of the primary trend's movement. For example, if the primary upward trend moved the DJIA from 10,000 to 12,500 (2,500 points), the secondary trend would be expected to send the DJIA down at least 833 points (one-third of 2,500).

Another important characteristic of a secondary trend is that its moves are often more volatile than those of the primary move.

• Minor Trend

The last of the three trend types in Dow theory is the minor trend, which is defined as a market movement lasting less than three weeks. The minor trend is generally the corrective moves within a secondary move, or those moves that go against the direction of the secondary trend.

Figure 5

Due to its short-term nature and the longer-term focus of Dow theory, the minor trend is not of major concern to Dow theory followers. But this doesn't mean it is completely irrelevant; the minor trend is watched with the large picture in mind, as these short-term price movements are a part of both the primary and secondary trends.

Most proponents of Dow theory focus their attention on the primary and secondary trends, as minor trends tend to include a considerable amount of noise. If too much focus is placed on minor trends, it can to lead to irrational trading, as traders get distracted by short-term volatility and lose sight of the bigger picture.

Stated simply, the greater the time period a trend comprises, the more important the trend.

4. The Three Phases Of Primary Trends

Since the most vital trend to understand is the primary trend, this leads into the third tenet of Dow theory, which states that there are three phases to every primary trend – the accumulation phase (distribution phase), the public participation phase and a panic phase (excess phase).

Let us now take a look at each of the three phases as they apply to both bull and bear markets.

Primary Upward Trend (Bull Market)

The Accumulation Phase
The first stage of a bull market is referred to as the accumulation phase, which is the start of the upward trend. This is also considered the point at which informed investors start to enter the market.

The accumulation phase typically comes at the end of a downtrend, when everything is seemingly at its worst. But this is also the time when the price of the market is at its most attractive level because by this point most of the bad news is priced into the market, thereby limiting downside risk and offering attractive valuations.

However, the accumulation phase can be the most difficult one to spot because it comes at the end of a downward move, which could be nothing more than a secondary move in a primary downward trend - instead of being the start of a new uptrend. This phase will also be characterized by persistent market pessimism, with many investors thinking things will only get worse.

From a more technical standpoint, the start of the accumulation phase will be marked by a period of price consolidation in the market. This occurs when the downtrend starts to flatten out, as selling pressure starts to dissipate. The mid-to-latter stages of the accumulation phase will see the price of the market start to move higher.

Figure 1: the accumulation phase

A new upward trend will be confirmed when the market doesn't move to a consecutively lower low and high.

Public Participation Phase
When informed investors entered the market during the accumulation phase, they did so with the assumption that the worst was over and a recovery lay ahead. As this starts to materialize, the new primary trend moves into what is known as the public participation phase.

During this phase, negative sentiment starts to dissipate as business conditions - marked by earnings growth and strong economic data - improve. As the good news starts to permeate the market, more and more investors move back in, sending prices higher.

This phase tends not only to be the longest lasting, but also the one with the largest price movement. It's also the phase in which most technical and trend traders start to take long positions, as the new upward primary trend has confirmed itself - a sign these participants have waited for.

Figure 2: the public participation phase

The Excess Phase
As the market has made a strong move higher on the improved business conditions and buying by market participants to move starts to age, we begin to move into the excess phase. At this point, the market is hot again for all investors.

The last stage in the upward trend, the excess phase, is the one in which the smart money starts to scale back its positions, selling them off to those now entering the market. At this point, the market is marked by, as Alan Greenspan might say, "irrational exuberance". The perception is that everything is running great and that only good things lie ahead.

This is also usually the time when the last of the buyers start to enter the market - after large gains have been achieved. Like lambs to the slaughter, the late entrants hope that recent returns will continue. Unfortunately for them, they are buying near the top.

During this phase, a lot of attention should be placed on signs of weakness in the trend, such as strengthening downward moves. Also, if the upward moves start to show weakness, it could be another sign that the trend may be near the start of a primary downtrend.

Figure 3: the excess phase

Figure 3: the excess phase

 Primary Downward Trend (Bear Market)

The Distribution Phase

The first phase in a bear market is known as the distribution phase, the period in which informed buyers sell (distribute) their positions. This is the opposite of the accumulation phase during a bull market in that the informed buyers are now selling into an overbought market instead of buying in an oversold market.

In this phase, overall sentiment continues to be optimistic, with expectations of higher market levels. It is also the phase in which there is continued buying by the last of the investors in the market, especially those who missed the big move but are hoping for a similar one in the near future.

As was the case in the accumulation phase, the distribution phase can be difficult to spot in its early stages. The reason for this is that it may be disguised as a secondary downward trend within the primary upward trend.

From a technical standpoint, the distribution phase is represented by a topping of the market where the price movement starts to flatten as selling pressure increases . The mid to latter stages of the distribution phase will see prices start to fall as more and more investors, anticipating weakness, exit their positions.

A new downward trend will be confirmed when the previous trend fails to make another consecutive higher high and low.

 Public Participation Phase

This phase is similar to the public participation phase found in a primary upward trend in that it lasts the longest and will represent the largest part of the move - in this case downward.

During this phase it is clear that the business conditions in the market are getting worse and the sentiment is becoming more negative as time goes on. The market continues to discount the worsening conditions as selling increases and buying dries up.

This is also the point at which most trend followers and technical traders start to dump their positions and take short positions as the new downward trend has confirmed itself.

The Panic Phase

The last phase of the primary downward market tends to be filled with market panic and can lead to very large sell-offs in a very short period of time. In the panic phase, the market is wrought up with negative sentiment, including weak outlooks on companies, the economy and the overall market.

During this phase you will see many investors selling off their stakes in panic. Usually these participants are the ones that just entered the market during the excess phase of the previous run-up in share price.

But just when things start to look their worst is when the accumulation phase of a primary upward trend will begin and the cycle repeats itself.