This method holds good in watching and determining the flood tide of the stock market. Confirmation by both is an integral part of the Dow Theory. The "few hypotheses": Manipulation is possible day-to-day but the primary trend cannot be manipulated. The Averages discount everything except acts of God.
|Published (Last):||10 September 2004|
|PDF File Size:||10.88 Mb|
|ePub File Size:||8.26 Mb|
|Price:||Free* [*Free Regsitration Required]|
Developed by Charles Dow, refined by William Hamilton and articulated by Robert Rhea, Dow Theory addresses not only technical analysis and price action, but also market philosophy.
Many of the ideas and comments put forth by Dow and Hamilton became axioms of Wall Street. At a high level, Dow Theory describes market trends and how they typically behave.
At a more granular level, it provides signals that can be used to identify and subsequently trade with the primary market trend. The theory centers around identifying the trend for the Dow Jones Rail now Transportation Average and the Dow Jones Industrial Average, and using volume to confirm those trends. If both Dow Jones averages are trending in the same direction, then the entire market can be said to be trending in that direction as well.
Investors can use these signals to identify the primary market trend, and then trade with that trend. Background Charles Dow developed Dow Theory from his analysis of market price action in the late 19th century.
Although he never wrote a book on these theories, he did write several editorials that reflected his views on speculation and the role of the rail and industrial averages. Nelson and William Hamilton who later refined the theory into what it is today.
Hamilton also wrote The Stock Market Barometer in , which sought to explain the theory in detail. Rhea read, studied and deciphered some editorials through which Dow and Hamilton conveyed their thoughts on the market.
Assumptions Before one can begin to accept Dow Theory, there are a number of assumptions that must be accepted. Rhea stated that for the successful application of Dow Theory, these assumptions must be accepted without reservation. Manipulation The first assumption is that the manipulation of the primary trend is not possible. When large amounts of money are at stake, the temptation to manipulate is bound to be present.
Hamilton did not argue against the possibility that speculators, specialists or anyone else involved in the markets could manipulate the prices. He qualified his assumption by asserting that it was not possible to manipulate the primary trend. Intraday, day-to-day and possibly even secondary movements could be prone to manipulation. These short movements, from a few hours to a few weeks, could be subject to manipulation by large institutions, speculators, breaking news or rumors.
Today, Hamilton would likely add message boards and day-traders to this list. Hamilton went on to say that individual shares could be manipulated. Examples of manipulation usually end the same way: the security runs up and then falls back and continues the primary trend. Examples include: PairGain Technology rose sharply due to a hoax posted on a fake Bloomberg site. However, once the hoax was revealed, the stock immediately fell back and returned to its primary trend.
Books-A-Million rose from 3 to 47 after announcing an improved web site. Three weeks later, the stock settled around 10 and drifted lower from there. While these shares were manipulated over the short term, the long-term trends prevailed after about a month. Hamilton also pointed out that even if individual shares were being manipulated, it would be virtually impossible to manipulate the market as a whole.
The market was simply too big for this to occur. Averages Discount Everything The second assumption is that the market reflects all available information. Everything there is to know is already reflected in the markets through the price. Prices represent the sum total of all the hopes, fears and expectations of all participants.
Interest rate movements, earnings expectations, revenue projections, presidential elections, product initiatives and all else are already priced into the market. The unexpected will occur, but usually this will only affect the short-term trend. The primary trend will remain unaffected. The chart below of Coca-Cola KO is a relatively recent example of the primary trend remaining intact.
The downtrend for Coca-Cola began with the sharp fall from above The stock rallied with the market in October and November , but by December started to decline again. It is likely that the stock was caught up in the general market advance at the time. However, when the major indices were hitting new highs in December, Coca-Cola was starting to flounder and resume its primary trend.
Hamilton noted that sometimes the market would react negatively to good news. For Hamilton, the reasoning was simple: the market looks ahead. By the time the news hits the street, it is already reflected in the price.
As the rumor begins to filter down, buyers step in and bid the price up. By the time the news hits, the price has been bid up to fully reflect the news. YHOO and the run-up to earnings is a classic example. For the first three quarters of , Yahoo! Hamilton and Dow readily admit that Dow Theory is not a sure-fire means of beating the market. It is looked upon as a set of guidelines and principles to assist investors and traders with their own study of the market.
Dow Theory provides a mechanism for investors to use that will help remove some of the emotion. Hamilton warns that investors should not be influenced by their own wishes. When analyzing the market, make sure you are objective and see what is there, not what you want to see.
If an investor is long, he or she may want to see only the bullish signs and ignore any bearish signals. Conversely, if an investor is out of the market or short, he or she may be apt to focus on the negative aspects of the price action and ignore any bullish developments. Dow Theory provides a mechanism to help make decisions less ambiguous.
The methods for identifying the primary trend are clear-cut and not open to interpretation. Even though the theory is not meant for short-term trading, it can still add value for traders. No matter what your timeframe, it always helps to be able to identify the primary trend. According to Hamilton writing in the early part of the 20th century , those who successfully applied Dow Theory rarely traded more than four or five times a year.
Remember that intraday, day-to-day and possibly even secondary movements can be prone to manipulation, but the primary trend is immune from manipulation. Hamilton and Dow sought a means to filter out the noise associated with daily fluctuations. They were not worried about a couple of points or getting the exact top or bottom; their main concern was catching the large moves. Both Hamilton and Dow recommended close study of the markets on a daily basis, but they also sought to minimize the effects of random movements and concentrate on the primary trend.
It is easy to get caught up in the madness of the moment and forget the primary trend. In our example above, the primary trend for Coca-Cola remained bearish after the October low.
Even though there were some sharp advances, the stock never forged a higher high. Some are more broadly-focused, describing general market behavior, while others address specific signals that can be used to identify and confirm market trends.
This section covers some of the broader theorems describing the types and behaviors of market trends. Market Movements Dow and Hamilton identified three types of price movements for the Dow Jones Industrial and Rail averages: primary movements, secondary movements and daily fluctuations.
Primary moves, which can last from a few months to many years, represent the broad underlying trend of the market. Secondary or reaction movements, which can last from a few weeks to a few months, move counter to the primary trend. Daily fluctuations can move with or against the primary trend and last from a few hours to a few days, but usually not more than a week.
Primary Movement Primary movements represent the broad underlying trend of the market and can last from a few months to many years. These movements are typically referred to as bull and bear markets.
Once the primary trend has been identified, it will remain in effect until proved otherwise. We will address the methods for identifying the primary trend later in this article. Hamilton believed that the length and the duration of the trend were largely indeterminable. Hamilton did study the averages and came up with some general guidelines for length and duration, but warned against attempting to apply these as rules for forecasting.
Many traders and investors get hung up on price and time targets. The reality of the situation is that nobody knows where and when the primary trend will end. Through a set of guidelines, Dow Theory enables investors to identify the primary trend and invest accordingly. Trying to predict the length and the duration of the trend is an exercise in futility. Hamilton and Dow were mainly interested in catching the big moves of the primary trend. Success, according to Hamilton and Dow, is measured by the ability to identify the primary trend and stay with it.
Secondary Movements Secondary movements run counter to the primary trend and are reactionary in nature. In a bull market, a secondary move is considered a correction. In a bear market, secondary moves are sometimes called reaction rallies. Earlier in this article, a chart of Coca-Cola was used to illustrate reaction rallies or secondary movements within the confines of a primary bear trend.
Below is a chart illustrating a correction within the confines of a primary bull trend. From trough to peak, the primary advance rose points. By the end of March, after three consecutive weeks of decline, it became apparent that this move was not in the category of daily fluctuations and could be considered a secondary move. Hamilton noted some characteristics that were common to many secondary moves in both bull and bear markets.
These characteristics should not be construed as rules, but rather as loose guidelines to be used in conjunction with other analysis techniques. The first three characteristics have been applied to the example above.
Hamilton also noted that secondary moves tend to be faster and sharper than the preceding primary move. Just with a visual comparison, we can see that the secondary move was sharper than the preceding primary advance.
The secondary move witnessed a correction of At the end of the secondary move, there is usually a dull period just before the turnaround.
Six basic tenets of Dow theory[ edit ] The market has three movements 1 The "main movement", primary movement or major trend may last from less than a year to several years. It can be bullish or bearish. The three movements may be simultaneous, for instance, a daily minor movement in a bearish secondary reaction in a bullish primary movement. Market trends have three phases Dow theory asserts that major market trends are composed of three phases: an accumulation phase, a public participation or absorption phase, and a distribution phase. The accumulation phase phase 1 is a period when investors "in the know" are actively buying selling stock against the general opinion of the market. During this phase, the stock price does not change much because these investors are in the minority demanding absorbing stock that the market at large is supplying releasing. Eventually, the market catches on to these astute investors and a rapid price change occurs phase 2.