Dow Theory
Dow Theory
● ● ● ● ●
History Ideal Market Picture Hypotheses Six Tenets Criticisms
Charles Dow ●
Father of Technical Analysis.
●
First recorded creation of an Index to measure the market.
●
His writings from the Wall St Journal were later formalized into “Dow Theory” by William Hamilton and Robert Rhea.
●
Rhea organized the writings into hypotheses and theorems.
Dow’s Ideal Market Picture ●
The ideal market consists of ○
Bottom (Accumulation) Top
○
Uptrend
○
Top (Distribution) Downtrend
○
Downtrend
Uptrend
Bottom
Dow Theory Hypotheses ●
The primary trend is inviolate. ○ ○ ○
●
●
Lots of manipulation was going on. Dow theorized that the effect was in the shorter terms. Primary trends could not be manipulated.
○ ○ ○
Dow Theory is not infallible. ○ ○
Dow, Hamilton & Rhea knew that this was not a “magic” formula. They believed that study of the indices would reveal the probability of the market continuing or reversing.
The averages discount everything.
○
●
Investors only studied individual stocks. Dow suggested that the Indices foretold the shape of the industry. This was beneficial in understanding the health of the economy. All of Wall St’s knowledge is represented in the price of the averages.
From this the Dow Theory Tenets were derived.
Dow Theory Tenets - 1. Trends ●
The market has three movements (waves). a.
The Primary Trend Months to Years.
b.
The Secondary Trend Ten days to three months.
c.
The Minor or Short-Term Trend Hours to a month.
d.
Dow suggested traders avoid trying to predict the secondary trend. Trade with the Trend!
Dow Theory Tenets - 1. Trends ● ●
Primary trends develop in three phases. Bull Market Phases a.
b.
c.
●
Bear Market Phases a.
Distribution Investors “In the Know” are actively selling into the public elation.
b.
Panic Prices decline faster than anytime in the Bull market rise. Everyone wants to liquidate. Borrowers have no options but to sell.
c.
Lack of Interest Investors do not want to experience that again. All stocks are undervalued. All news is negative and pessimism prevails.
Accumulation Investors “In the Know” are actively buying against public opinion. Participation (Absorption) Increasing Volume. More investors get involved. Secondary stocks become popular. Final explosive move Excessive speculation and public elation. Buying becomes indiscriminate. Investors borrow to buy stocks.
Schabacker’s Rules How to identify the end of a Primary Trend ●
End of a Bull Market
●
End of a Bear Market
○
Trading volume increases sharply.
○
Trading volume is low.
○
Popular stocks advance while others collapse.
○
Commodity prices have declined.
○
Interest rates have declined.
○
Corporate earnings are low.
○
Stock prices have been steadily declining and bad news is everywhere.
○ ○
○
Interest rates are high. Stocks become a popular topic of conversation. Warnings about an overheated market appear on the news.
Characteristics of a Secondary Reaction ●
The most difficult thing is to determine if a retracement is a secondary reaction or a change in the primary trend.
●
Secondary reactions have some characteristics that we can identify.
●
The reaction is over once prices reach new highs.
●
Characteristics: ○ ○ ○ ○
○ ○
There are a number of clear downswings (in a bull market). The movement is more rapid in the reversal than in the primary move. The reactions last from 3 weeks to 3 months. If the volume during the reaction is equal (or greater) than the volume prior to the reaction, then a bear market is likely. Lower volume confirms it is a reaction. If there has been a lot of speculation, a bear market is likely.
Dow Theory Tenets - 2. Discounts News ●
There are two common variants of this tenant: 1.
The stock market discounts all news. i. Stock prices reflect all known knowledge. ii. New information (News) is quickly reflected in the stock price.
2.
The averages discount everything i. Dow’s era was rife with manipulation. ii. By using averages (indices), Dow was able to minimise the effect of a single stock move.
Dow Theory Tenets - 3. Confirmation ●
Stock market averages must confirm. a. Wanted to see confirmation between
d.
Primary upward trend was only established when both averages posted higher peaks.
e.
Conclusions based on the movement of one average, unconfirmed by the other, are almost certain to prove misleading.” (Rhea 1932)
f.
Today we can use S&P 500 and Russell 2000 as they better represent the Industrials and the high growth segments.
Industrials and Railroads.
b.
Industry could not bring products to market without rail. Growth in Industrials was not sustainable without growth in Railroads.
c.
Primary downward trend was only established when both averages posted lower troughs.
Confirmation - Industrials and Transportation
Confirmation - S&P500 and Russell 2000
Dow Theory Tenets - 4. Volume ●
Trends are confirmed by volume. a.
Price moves on low volume could be an over-zealous buyer and not reflect the sentiment of the market.
b.
Price moves accompanied by strong volume reflect the “True” market view.
Dow Theory Tenets - 5. Only use Closes ●
Dow believed that only the closing price of the day should be used.
●
Intra-day traders have liquidated positions.
●
Large funds typically executed at the end of the day.
●
Today we still see higher volume at the end of a trading day.
Dow Theory Tenets - 6. Trends Persist ●
Trends exist until definitive signals prove they have ended. a.
Dow believed that trends existed despite "market noise".
b.
Counter-moves are expected and do not signal a change in trend.
c.
The trend should be given the benefit of the doubt until the change is obvious.
d.
Technical Analysis tries to solve this.
Criticisms of Dow Theory ●
Signals lag changes in trend. ○ ○
●
Reduced profits Reduced risk
Trends are not strictly defined.
Dow Theory
● ● ● ● ●
History Ideal Market Picture Hypotheses Six Tenets Criticisms
● ● ● ● ●
History Ideal Market Picture Hypotheses Six Tenets Criticisms
Charles Dow ●
Father of Technical Analysis.
●
First recorded creation of an Index to measure the market.
●
His writings from the Wall St Journal were later formalized into “Dow Theory” by William Hamilton and Robert Rhea.
●
Rhea organized the writings into hypotheses and theorems.
Dow’s Ideal Market Picture ●
The ideal market consists of ○
Bottom (Accumulation) Top
○
Uptrend
○
Top (Distribution) Downtrend
○
Downtrend
Uptrend
Bottom
Dow Theory Hypotheses ●
The primary trend is inviolate. ○ ○ ○
●
●
Lots of manipulation was going on. Dow theorized that the effect was in the shorter terms. Primary trends could not be manipulated.
○ ○ ○
Dow Theory is not infallible. ○ ○
Dow, Hamilton & Rhea knew that this was not a “magic” formula. They believed that study of the indices would reveal the probability of the market continuing or reversing.
The averages discount everything.
○
●
Investors only studied individual stocks. Dow suggested that the Indices foretold the shape of the industry. This was beneficial in understanding the health of the economy. All of Wall St’s knowledge is represented in the price of the averages.
From this the Dow Theory Tenets were derived.
Dow Theory Tenets - 1. Trends ●
The market has three movements (waves). a.
The Primary Trend Months to Years.
b.
The Secondary Trend Ten days to three months.
c.
The Minor or Short-Term Trend Hours to a month.
d.
Dow suggested traders avoid trying to predict the secondary trend. Trade with the Trend!
Dow Theory Tenets - 1. Trends ● ●
Primary trends develop in three phases. Bull Market Phases a.
b.
c.
●
Bear Market Phases a.
Distribution Investors “In the Know” are actively selling into the public elation.
b.
Panic Prices decline faster than anytime in the Bull market rise. Everyone wants to liquidate. Borrowers have no options but to sell.
c.
Lack of Interest Investors do not want to experience that again. All stocks are undervalued. All news is negative and pessimism prevails.
Accumulation Investors “In the Know” are actively buying against public opinion. Participation (Absorption) Increasing Volume. More investors get involved. Secondary stocks become popular. Final explosive move Excessive speculation and public elation. Buying becomes indiscriminate. Investors borrow to buy stocks.
Schabacker’s Rules How to identify the end of a Primary Trend ●
End of a Bull Market
●
End of a Bear Market
○
Trading volume increases sharply.
○
Trading volume is low.
○
Popular stocks advance while others collapse.
○
Commodity prices have declined.
○
Interest rates have declined.
○
Corporate earnings are low.
○
Stock prices have been steadily declining and bad news is everywhere.
○ ○
○
Interest rates are high. Stocks become a popular topic of conversation. Warnings about an overheated market appear on the news.
Characteristics of a Secondary Reaction ●
The most difficult thing is to determine if a retracement is a secondary reaction or a change in the primary trend.
●
Secondary reactions have some characteristics that we can identify.
●
The reaction is over once prices reach new highs.
●
Characteristics: ○ ○ ○ ○
○ ○
There are a number of clear downswings (in a bull market). The movement is more rapid in the reversal than in the primary move. The reactions last from 3 weeks to 3 months. If the volume during the reaction is equal (or greater) than the volume prior to the reaction, then a bear market is likely. Lower volume confirms it is a reaction. If there has been a lot of speculation, a bear market is likely.
Dow Theory Tenets - 2. Discounts News ●
There are two common variants of this tenant: 1.
The stock market discounts all news. i. Stock prices reflect all known knowledge. ii. New information (News) is quickly reflected in the stock price.
2.
The averages discount everything i. Dow’s era was rife with manipulation. ii. By using averages (indices), Dow was able to minimise the effect of a single stock move.
Dow Theory Tenets - 3. Confirmation ●
Stock market averages must confirm. a. Wanted to see confirmation between
d.
Primary upward trend was only established when both averages posted higher peaks.
e.
Conclusions based on the movement of one average, unconfirmed by the other, are almost certain to prove misleading.” (Rhea 1932)
f.
Today we can use S&P 500 and Russell 2000 as they better represent the Industrials and the high growth segments.
Industrials and Railroads.
b.
Industry could not bring products to market without rail. Growth in Industrials was not sustainable without growth in Railroads.
c.
Primary downward trend was only established when both averages posted lower troughs.
Confirmation - Industrials and Transportation
Confirmation - S&P500 and Russell 2000
Dow Theory Tenets - 4. Volume ●
Trends are confirmed by volume. a.
Price moves on low volume could be an over-zealous buyer and not reflect the sentiment of the market.
b.
Price moves accompanied by strong volume reflect the “True” market view.
Dow Theory Tenets - 5. Only use Closes ●
Dow believed that only the closing price of the day should be used.
●
Intra-day traders have liquidated positions.
●
Large funds typically executed at the end of the day.
●
Today we still see higher volume at the end of a trading day.
Dow Theory Tenets - 6. Trends Persist ●
Trends exist until definitive signals prove they have ended. a.
Dow believed that trends existed despite "market noise".
b.
Counter-moves are expected and do not signal a change in trend.
c.
The trend should be given the benefit of the doubt until the change is obvious.
d.
Technical Analysis tries to solve this.
Criticisms of Dow Theory ●
Signals lag changes in trend. ○ ○
●
Reduced profits Reduced risk
Trends are not strictly defined.
Dow Theory
● ● ● ● ●
History Ideal Market Picture Hypotheses Six Tenets Criticisms
