Dow Theory

| December 20, 2005

Charles Dow is known to many as the Father of stock market technical analysis. In the late 19th century, he founded The Wall Street Journal and the Dow Jones news service, and created the first stock tracking index, the Dow Jones Industrial Average. Through his daily observations of this average, Dow was the first to identify bull and bear market trends, along with patterns of behavior that enabled him to make remarkably reliable predictions about future price movements. His market observations, which were initially published in Wall Street Journal editorials, became the foundation of what would later be known as Dow Theory.

What is Dow Theory?

At its core, Dow Theory is concerned with values. The fundamental tenet of Dow Theory is that stock prices are engaged in a perpetual cycle that takes markets from areas of undervaluation to areas of overvaluation, and then back again. The idea is that, at any given point in time, one of two different primary trends is in force, either a bull or a bear. A bull primary trend moves the market from areas of undervaluation to areas of overvaluation, and a bear primary trend moves them back again to undervaluation. Further, an investment portfolio based upon Dow Theory seeks to be fully invested in the market during bull trends, and out of stocks during their bear counterparts. Essentially, it’s that simple, although it does also provide some tools which aid the practioner in the crucial task of identifying primary trends and changes in them.

Dow Theory History

Charles Dow probably had no idea that his musings on the stock market would one day form the basis of an entire investment and trading strategy. He published his observations in a series of editorials in the Wall Street Journal, and an admirer of his work, S.A. Nelson, compiled “Dow’s Theory” in a book entitled “The ABC of Stock Speculation.” Published in 1903, it was perhaps the first technical analysis work ever printed.

After Dow’s death, Dow Theory was advanced by a subsequent editor of The Wall Street Journal, William Peter Hamilton. Hamilton refined Dow’s ideas, publishing his own version of the theory in his 1922 book, “The Stock Market Barometer.” Hamilton, like Dow before him, published his observations and predictions in editorials, and he gained recognition for the insight and prescience of his musings. His most famous call occurred in late October, 1929 when he proclaimed the start of a secular bear market only days before the infamous two-day crash of Black Monday and Tuesday.

Upon Hamilton’s death, the Dow Theory cause was taken-up by a newsletter writer by the name of Robert Rhea. His published work also attained notoriety for its innovation, and his service was one of the most successful of the 1930s. He refined theory principles further, developing it into a fully realized investment and trading platform. Since the time of Rhea, many have have practiced Dow Theory, with the most recent and arguably the most famous being the incomparable Richard Russell of Dow Theory Letters.

Dow Theory Principles

Trends and Price Movement

Under Dow Theory, a bull primary trend is said to be in effect so long as the market continues to make higher highs and higher lows, while a bear market is in effect so long as it continues to make lower lows and lower highs. The following weekly chart of the S&P 500 index is an excellent example of a bull primary trend in effect:

Notice that every correction in the uptrend is followed by a rally that moves beyond the peak of the preceding rally, and corrections do not move below previous correction lows. This is what is meant by “higher highs and higher lows.” The opposite is then true for bear trends.

Further, primary trend changes occur when one trending pattern shifts to the other. For example, in the above chart, if the next rally after a correction in the uptrend failed to move beyond the peak of the previous rally, and then the subsequent move down violated the low of the previous correction, that would be a Dow Theory bearish signal, as one pattern transforms into the other.

Trends Within Trends

Dow also observed that trends contained smaller trends within them, and these smaller trends themselves were composed of even smaller movements. In his studies, he grouped price movements into three, different trend categories:

  1. The Primary Trend: This is the main force in price movements, driven by economic expansion and contraction, with a typical duration of several years.
  2. The Secondary Trend: This is the price movement that is counter to the primary trend, and acts as a corrective measure; during a primary bull trend, corrections are sell-offs, while in a primary bear trend, corrections are rallys. The typical duration of a secondary trend is anywhere from 3 weeks to 3 months.
  3. Daily Fluctuations: These are the highly volatile and unpredictable price movements of day-to-day trading activity. There is generally very little useful predictive information in these shortest of trends, and they only have any meaning when taken in context of the secondary and primary trends.

The Market Expert

Also at the heart of Dow Theory is the idea that markets themselves are the best predictors of future market behavior. Analysts, economists, and experts of all kinds regularly make predictions about the future course of the economy and the stock market based upon all manner of economic indicators and statistics. However, people who claim to know what stock prices will do next week or next month are either kidding you, or kidding themselves. In the final analysis, the only accurate assessment of price movement is provided by the actual price movement itself. Stock market indices such as the Dow Jones Industrial Average and the S&P 500 tally all of the buy and sell decisions made by every market participant and render an objective, real-time verdict on future prospects every moment of every day.

Remember, stock prices today are a reflection of things to come, not a reflection of the here and now. The real trick is to understand what the market averages are saying when they speak. Many quote the old adage, “The market is always right!” We don’t quite agree with that sentiment, as markets are oftentimes more a reflection of the irrational nature of their human participants than underlying fundamentals. Was the market “right” when the NASDAQ composite hit 5,000 in March of 2000? We would argue that it was not. The key, as an investor, is not to be “right” or “wrong,” but, again, to understand what the market is saying at any given point in time and agree with it. After all, sometimes the market is right and sometimes it’s wrong, but it never loses an argument. It was once said that “Wall Street is littered with the corpses of those who were right too early.” We would amend that expression to “Wall Street is littered with the corpses of those who disagreed with the market.”

The Classic Dow Theory Signal

Most investors know very little about Dow Theory, but, when asked what it is, they’ll probably say something about “indices confirming each other.” What they are referring to is the classic, Dow Theory trend change signal. As we outlined above in the “Trends and Price Movement” section, trend changes are said to occur when one pattern of alternating highs and lows changes to the other. However, when attempting to identify changes in the primary trend, Dow believed that this pattern change must occur in both the Dow Jones Industrial Average and the Dow Jones Transport Average in order for a given trend change signal to be valid. His reasoning was that, if a significant change in the course of the economy were looming, it would be predicted by both the large, blue-chip companies of the Industrials Average and the transportation companies of the Transports Average. He also noted that non-confirmations, or trend change signals occurring on one average but not the other, tended to be deceptive, historically. Therefore, he recommended only considering confirmed signals as valid.

A Foundation for Success

In the final analysis, what Dow Theory provides to its practitioners is a set of tenets and tools that assist in making sense of the complex world of investing. What it is not is a crystal ball; when it comes to analyzing a system as complex as the stock market, there is no such thing. However, understanding and applying Dow Theory principles does provide a proven foundation for achieving investment success over the long-term, which is why it plays such a large part in our strategy here at PMI.

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