Charles H. 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)
- Uptrend
- Top (Distribution)
- Downtrend
Dow Theory Hypothesis
- 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.
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- The averages discount everything
- Inventors 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
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Dow Theory Tenets – 1. Trends
- The market has three movements (waves).
- The Primary Trend Months to Years.
- The Secondary Trend is ten days to three months.
- The Minor or Short-Term Trend Hours to a month
- 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
- 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.
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- Bear Market Phases
- Distribution: Investors “In the Know” are actively selling into the public elation.
- Panic: Prices decline faster than any time in the Bull market rise. Everyone wants to liquidate. Borrowers have no options but to sell.
- Lack of Interest: Investors do not want to experience that again. All stocks are undervalued. All news is negative and pessimism prevails.
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Schabacker’s Rules
How to identify the end of a Primary Trend
- End of a Bull Market
- Tracking volume increases sharply
- Popular stocks advance while others collapse.
- Interest rates are high
- Stocks become a popular topic of conversation.
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- End of a Bear Market
- Trading volume is low
- Commodity prices have declined.
- Interest rates have declined.
- Corporate earnings are low.
- Stock prices have been steadily declining and bad news is everywhere.
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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.
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- 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.
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Dow Theory Tenets – 2. Discounts News
There are two common variants of this tenets
- The stock market discounts all news.
- Stock prices reflect all known knowledge.
- New information (News) is quickly reflected in the stock price.
- The averages discount everything
- Dow’s era was rife with manipulation.
- By using averages (indices), Dow was able to minimize the effect of a single stock move.
Dow Theory Tenets – 3. Confirmation
- Stock market averages must confirm.
- Wanted to see confirmation between Industrials and Railroads.
- Industry could not bring products to market without rail. Growth in industrials was not sustainable without growth in Railroads.
- Primary downward trend was only established when averages posted lower troughs.
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- Primary upward trend was only established when both averages posted higher peaks.
- Conclusions based on the movement of one average, unconfirmed by the other, are almost certain to prove misleading. (Rhea 1932)
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Dow Theory Tenets – 4. Volume
- Trends are confirmed by volume.
- Price moves on low volume could be an over-zealous buyer and not reflect the sentiment of the market.
- 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.
- Dow believed that trends existed despite “market noise”.
- Counter-moves are expected and do not signal a change in trend.
- The trend should be given the benefit of the doubt until the change is obvious.
- Technical Analysis tries to solve this.
Criticism of Dow Theory
- Signals lag changes in trend.
- Reduced profits
- Reduced risk
- Trends are not strictly defined.
