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Dow Theory is based on the original writings of Charles H. Dow before
his death in 1902 and on the refinements of his successor, William P.
Hamilton, from 1902 to 1929.
There are Three Trends: Primary, Secondary, and Minor. The whole point
of this time-honored theory is the identification of the all-important,
long-term Primary Tide of the stock market. The Primary Trend (the Tide)
is the major trend that usually last a year to several years and moves
more than 20%--up more than 20% is called a Bull Market, while down more
than 20% is called a Bear Market.
The Secondary Trend (the Wave) is a reaction or correction in the
opposite direction to the Primary Trend. This "intermediate-term"
Secondary Wave usually lasts from three to 13 weeks (seldom longer). It
typically retraces one-third, one-half, or two-thirds of the preceding
Primary Tide swing.
The Minor Trend (the Ripple) lasts only one to fifteen trading days. It
is ignored as insignificant noise by the Dow Theory.
The Primary Tide has three phases. In a Bull Market, the first phase is
accumulation, when the smart money bids for out-of-favor, depressed
stocks at bargain prices. Fundamentals appear bleak. Transactional
volume, which has been low, starts to improve on rallies.
The second Bull phase is known as the mark-up as stock prices rise on
increasing transactional volume. Fundamentals appear to improve.
The third Bull phase is marked by popular enthusiasm and speculation on
heavy transactional volume. Fundamentals appear extremely optimistic.
Divergences appear as irrational players buy the wrong stocks and the
smart money liquidates the best stocks.
In a Bear Market, the first phase is distribution, when the smart money
offers out overvalued stocks at absurdly high prices. Fundamentals
appear so positive that there is widespread talk of a "new era" of never
ending prosperity. Transactional volume, which has been high, starts to
diminish on rallies, as greedy buyers run out of buying power after
becoming fully invested, or leveraged to the maximum on margin.
The second Bear phase is marked by panic as prices drop steeply on
extremely heavy transactional volume. Repeated waves of panic may sweep
the market. Some cracks begin to appear in the previously rosy
fundamentals.
The third Bear phase is characterized by discouraged selling.
Fundamentals appear to be deteriorating. Downward movement is
persistent, though less rapid than in the panic phase. Even the best
stocks suffer. Transactional volume, which was high in the panic phase,
starts to diminish on declines as liquidation nears completion.
Eventually, after everyone who could sell has sold already, the Bear
Market is exhausted, and a new Bull Market is born.
Although these phases have been written about for nearly full a century,
investors on the whole never seem to learn from history. It is all too
easy, it is merely human nature, to get caught up in the mass mood of
the moment and lose perspective.
To signal a change in the Primary Tide, both the Dow-Jones Industrial
Average and the Dow-Jones Transportation Average must confirm the change
by exceeding their preceding Secondary Wave reaction price extremes on
a closing price basis. The Dow Theory considers the last price of the
day only; in other words, closing price line charts. (The so-called
intraday highs and lows mean nothing.) In other words, to signal a
change from Bear Market to Bull Market, both the Dow-Jones Industrial
Average and the Dow-Jones Transportation Average must confirm the change
by closing above their preceding Secondary Wave reaction closing price
highs. To signal a change from Bull Market to Bear Market, both the
Dow-Jones Industrial Average and the Dow-Jones Transportation Average
must confirm the change by closing below their preceding Secondary Wave
reaction closing price lows.
The Dow Theory is traditionally interpreted very strictly, and for good
reason, it works. To emphasize the point, both averages must a confirm
a new Primary Tide--one alone means nothing. That is, so-called
divergences mean nothing, when one average exceeds a preceding Secondary
Wave reaction price extreme on a closing price basis but the other
average fails to confirm. It is not necessary that both averages confirm
on the same day or even the same month--one average may lead and the
other lag--but both must confirm or there is no signal. As a final
strict point, the most minimal unit of price measure for both averages
(down to 0.01 as published daily for both price averages) strictly
counts, with no rounding off, when comparing current levels in both
averages to their previous secondary wave levels.
Over the past 100 years, the Dow Theory has an extremely impressive long
term track record, trouncing the Passive Buy-and-Hold Strategy.
Copyright 1998
R. W. Colby
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