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The ideas of
Charles Dow, the first editor of the Wall
Street Journal, form the basis of technical
analysis today.
Dow created the Industrial Average, of top
blue chip stocks, and a second average of
top railroad stocks (now the Transport
Average). He believed that the behavior of
the averages reflected the hopes and fears
of the entire market. The behavior patterns
that he observed apply to markets throughout
the world.
Dow Theory
Three Movements
Market has a tendency to fluctuate. Markets fluctuate in more than one time
frame at the same time:
There are three well defined movements in
market which fit into each other.
- The first is the daily variation due
to local causes and the balance of buying
and selling at that particular time
(Ripple).
- The secondary movement covers a period
ranging from days to weeks, averaging
probably between six to eight weeks
(Wave).
- The third move is the great swing
covering anything from months to years,
averaging between 6 to 48 months. (Tide).
- Bull markets are broad upward
movements of the market that may last
several years, interrupted by secondary
reactions. Bear markets are long declines
interrupted by secondary rallies. These
movements are referred to as the primary
trend.
- Secondary movements normally retrace
from one third to two thirds of the
primary trend since the previous secondary
movement.
- Daily fluctuations are important for
short-term trading, but are unimportant in
analysis of broad market movements.
Various cycles have subsequently been
identified within these broad categories.
Dow Theory
Primary Movements have Three Phases
Some General Conditions in the market.
Bull markets
- Bull markets commence with reviving
confidence as business conditions improve.
- Prices rise as the market responds to
improved earnings
- Rampant speculation dominates the
market and price advances are based on
hopes and expectations rather than actual
results.
Bear markets
- Bear markets start with abandonment of
the hopes and expectations that sustained
inflated prices.
- Prices decline in response to
disappointing earnings.
- Distress selling follows as
speculators attempt to close out their
positions and securities are sold without
regard to their true value.
Ranging Markets
- A secondary reaction may take the form
of a ‘line’ which may endure for several
weeks.
- Price fluctuates within a narrow range
of about five per cent.
Breakouts from a range can occur in
either direction.
- Advances above the upper limit of the
line signal accumulation and higher
prices;
- Declines below the lower limit
indicate distribution and lower prices;
- Volume is used to confirm price
breakouts.
Dow Theory
Trends
Bull Trends
A bull trend is identified by a series of
rallies where each rally exceeds the highest
point of the previous rally. The decline,
between rallies, ends above the lowest point
of the previous decline.
Successive higher highs and higher
lows.
The start of an up trend is signaled when
price makes a higher low (trough), followed
by a rally above the previous high (peak):
Start = higher Low +
break above previous High.
The end is signaled by a
lower high (peak), followed by a decline
below the previous low (trough):
End = lower High +
break below previous Low.
What if the series of higher
Highs and higher Lows is first broken by a
lower Low? There are two possible
interpretations - see Large Corrections.
Bear Trends
Each successive rally fails
to penetrate the high point of the previous
rally. Each decline terminates at a lower
point than the preceding decline.
Successive lower highs and lower
lows.
A bear trend starts at the end of a bull
trend: when a rally ends with a lower peak
and then retreats below the previous low.
The end of a bear trend is identical to the
start of a bull trend.
What if the series of lower Highs and lower
Lows is first broken by a higher High? This
is a gray area - see Large Corrections.
Dow Theory
Large Corrections
A large correction occurs when price
falls below the previous low (during a bull
trend) or where price rises above the
previous high (in a bear trend).
Some purists argue that a trend ends if the
sequence of higher highs and higher lows is
broken. Others argue that a bear trend has
not started until there is a lower High and
Low nor has a bull trend started until there
is a higher Low and High.
For practical purposes: Only accept large
corrections as trend changes in the primary
trend:
- A bull trend starts when price rallies
above the previous high,
- A bull trend ends when price declines
below the previous low,
- A bear trend starts at the end of a
bull trend (and vice versa).
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