Dow Theory - Basic Assumptions

Dow Theory - The Basic Assumptions Charles Dow analysed the The DJ Industrial Average and DJ Rail Index and semi-published his papers on Dow Theory suggesting stock markets move in similar ways over time. He is thought of as the founder of Technical Analysis (TA), although Japanese rice traders were using a form of TA to predict future price action in the 1500's (See the module on price action). Dow's basics on Dow Theory still hold good today and are the basic assumptions chartists use in their TA to this day. 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. TA focuses mainly on the technical's of the chart, but will still have a handle on the broader fundamental activity. Having said that, Dow theory is much more suited to technical analysis. He died prior to publishing all his theories, but his works were completed by his associates and published in financial journals around the world. He believed that the stock markets were a good measure of business conditions and by analysis one could identify trends and predict future price movements. All traders using TA should get to know Dow's 6 Tenets (beliefs) and keep them in mind when using TA to form your trading strategies.

Tenet 1. Markets have 3 Trends Primary Trend The Primary Trend is the background trend of a stock or other security, shown on our Apple Chart below. Dow indicates that the Primary Trend will last between 1 and 3 years, but may vary in some circumstances (5 years in our Apple example). Today's analysts may think of the primary trend as Dow did, or he/she may shorten it - It all depends on your trading horizon. I.e. If you're a day trader, this primary trend may only last a few months to a year. As we go through the course, you'll grow to realise that Dow's Theories, although valid, can be interpreted differently to benefit modern trading. Anyway, this Primary Trend is the major trend in the market and will affect The Secondary and Minor market trends. One of the most basic rules of TA is trade with the trend (within your trading horizon) and not against the trend, so it's always prudent to look at the long term Primary Trend first when making trading decisions. You'll see in the Apple Inc chart below the primary trend is an up trend, lasting around 60 months. We are using a weekly chart, capturing the closing prices every Friday night. You can just as easily use a daily chart, capturing the closing price on a daily basis. It's important to note that trends aren't straight, but tend to go up and down in a zigzag motion making peaks and troughs along the way. Dow used Peak and Trough Analysis to identify these trends. We'll talk about this further in Module 1. The definition of an up trend is a trend making higher highs (higher peaks) and higher lows (higher troughs) and a down trend makes lower highs and lower lows. The zigzag nature of the trend can again be seen in the below chart of Apple, where the general primary trend is up (or bullish), but not exactly straight. This Primary Trend will stay in place until there is a trend reversal. This reversal is confirmed when the current price starts closing below a previous established trough in the last primary trend (if we have been in an up trend & vice-versa for a down trend). In our example Apple's price starts to reverse at the start of 2008 and the trend reversal is confirmed when the price makes lower lows and lower highs.

Dow Theory - Tenet 1. The 3 Trends of The Market Secondary Trend The Secondary Trend, or intermediate trend as it's often called, moves in the opposite direction to The Primary Trend, before the Primary Trend resumes - It's a correction to the Primary Trend. If the Secondary Trend takes place in a Primary Up Trend then the secondary trend will be down consisting of lower highs and lower lows. The secondary trend ends when the trend resumes to higher highs and higher lows. It's important to note that the secondary trend should not fall below the last observable trough of the primary trend. If it does, it's not a secondary trend and could be the making of a new primary countertrend. In our Apple example we can quite clearly see the secondary trend between Jan 06 and Jul 06, where the low of the secondary trend doesn't fall below the last trough in the primary trend (May 05). A selection of peaks and troughs have also been highlighted in our chart Charles Dow observed The secondary trend generally lasting up to 3 months and it's retracement generally between 33% and 66% of the primary trends latest move. The length of the secondary trend does vary and can be longer than 3 months, especially if we observe a long primary trend. Dow also observed that volatility was found to be greater than the primary trend. In our Apple example the secondary trend lasts 6 months against a 6 year primary trend and the secondary trend low in Jul 06 retraces 66% back to the last trough of the primary trend (May 05). Minor Trend A minor trend typically lasts less than 3 weeks and is generally the corrective moves to the secondary trend. Dow suggests traders and investors should concentrate on the primary and secondary trends as these minor trends are generally period of volatility and must be treated with the long term picture in view. They are in effect continuing the long term primary trend, but are brief and volatile. But they shouldn't be dismissed out of hand as they can provide trading opportunities. In our Apple example our minor trend lasts 4 weeks, which is a little longer than Dow suggests, but given the long length of the primary trend this is not unexpected.

Tenet 2. Trends have 3 Phases Charles Dow's second Tenet is "The market trend has 3 phases". These are called the Accumulation, Public Participation and Excess Phases in an up trend (or bull market) and The Distribution, Public Participation and Panic Phase in a down trend (or bear market). The Accumulation Phase (Bull Market) The Accumulation Phase is where the up trend start, which is usually at the bottom of a down trend (but not always). This is the point where the savvy, professional traders/investors enters the market at the best prices when the market is under valued. It is also the hardest phase of the up trend to spot, as it may look like the market is ranging and not trending. Technical Analysis can indicate entry into the accumulation phase, as this phase is often preceded by a consolidation phase from the previous

down trend. We'll go on to talk about this in our Module on Chart Patterns where reversals can be anticipated. You may also want to read the section on Retracement or Reversal - know the difference. Again we'll use Apple Inc to highlight these 3 phases to a trend. On our chart below the accumulation phase is seen between May 03 and Aug 04. For a more in depth analysis of Accumulation please see the section at the top of the right hand side bar. The Public Participation Phase (Bull Market) The Public Participation Phase happens after the good news starts to be taken on board by the general population. The Public then start buying sending prices ever higher. This phase doesn't necessarily have to be steeper than the Accumulation Phase, but it is generally the longer lasting where prices moves the most. In our Apple example The Public participation Phase starts Aug 04 and lasts until the end of 2007. The Excess Phase (Bull Market) In our Apple example the excess phase is seen between the start of 2007 and the end of 2007. This is the last part of the 3 phases within the primary trend and is where the market is gripped by a scramble to get on board before they miss the boat. Interestingly, this is where the savvy traders start to reduce their exposure and begin to take some profits. This is the part of the trend that traders should start looking for signs of upward momentum weakness. In our Apple example we can see some signs of weakness when large downside moves take place in the excess phase. Eventually a major sell-off results at the start of 2008. The excess phase is generally seen in a bubble market.

Dow Theory - Tenet 2. Trends have 3 Phases The Distribution Phase (Bear Market) This is the opposite to the accumulation phase, in that savvy traders sell or short there positions thinking that the market is overbought. Again, this phase is difficult to spot and buyers may still be coming into the market trying to capitalise on what they may have missed - it may even be a ranging market. Technical Analysis may be helpful here to identify this phase as it generally comes after an up trend and consolidation period. There's no example here, but just think of The Apple example flipped upside down. For a more in depth analysis of Distribution please see the section at the top of the right hand side bar. Public Participation Phase (Bear Market) As with the Public Participation in a bull market this is usually the longest portion of the trend with the largest price move. Trend followers will often exit the market here, or take a short position. (A short position is when a trader borrows shares from a broker and sells them on the open market. The

investor must eventually return the borrowed stock by buying it back from the open market, hoping the price will fall). The Panic Phase (Bear Market) Again, this is the flip of the excess phase. A jolt of negativity enters the market and a barrage of selling takes place sometimes at panic levels. Some savvy traders will start to look at entering the market at this point trying to profit on bad news. We'll go on to talk about trading on the news later.

Tenet 3. The Market Discounts all News What this means is that the stock markets, FX markets, commodity markets etc.. have priced in ALL news into the market as soon as it is released. The market is "information efficient" on all news, whether it be fundamental economic news, interest rate data, pending earnings announcements, or general sentiment. Even future shocks like natural disasters have a certain degree of pricing in the market. As soon as things change the market adjusts extremely quickly to reflect the new market valuation. This Tenet is one of the main arguments for Technical Analysis as TA only looks at predicting future price movements based on chart patterns, price action, historical support and resistance levels and technical indicators - not other factors like fundamental news. However, most Chartist using TA will have a broad knowledge of Fundamental activity before making that trade - I.e. They'll know how the broader market looks before drilling down to individual stocks, FX, etc.

Tenet 4. Market Indexes Confirm Each Other Dow Theory argues that similar indices must have a correlation as they have the same exposure to current economic conditions. For example The Dow Jones industrial Average must correlate with The Dow Jones Transportation Index. If there is any kind of divergence then Dow argues there will be a change in trend in one of the indexes, so it's difficult to predict where this new primary trend will begin or if the primary trend will develop at all. If they are in agreement then this can confirm the trend.

Tenet 5. Trends Must Be Confirmed by Volume If higher volumes accompany a rising/falling trend then this is a good indicator of a strong trend confirmation. If there are low volumes then the there still may be a trend, but it’s not as representative of the overall view. Dow Theory assumes that volume accompanies price movements as an indicator. It's a secondary indicator confirming price moves and so confirming the trend - volume should increase as the price trends up or down indicating more people are on board. In our Apple example, look how On-Balance Volume (the orange line at the bottom of the chart) steadily increases through the primary up trend. This is a confirmation of the trend by volume, so the majority of money in the market should be moving with the trend and not against it. On balance volume (OBV) is a technical indicator that we will talk about later in the course. In the mean time all we need to know is OBV provides a running total of volume and shows whether this volume is flowing in or out of a given security.

Dow Theory - Tenet 5. Trend must be Confirmed by Volume

Tenet 6. Trends Exist Until Definitive Signals Prove They Have Ended A clear trend reversal must happen before a new primary trend starts. The trend is usually ended with a change in business or economic conditions strong enough to force the trend change. A trend may go through a correction into a secondary trend before continuing the primary trend. Looking at Technical analysis will help to establish trend ending indicators. The goal of trend traders is not to mistake a correction with the start of a new primary trend. This is why they wait for the weight of evidence to conclude the trend has definitely ended.

Conclusion Dow Theory forms building blocks for Technical Analysis, however the world has changed in the last 100 years. The links between all the indexes are less intertwined, as technology indexes have taken hold and other world indexes have acquired greater importance. More analysis of different indexes is now required reducing the accuracy of Dow Theory. There's no doubt Dow Theory is still important to TA though. Trending markets, market emotions and peak and trough analysis are found throughout TA so Dow Theory must be understood.