Six basic tenets of Dow
Theory
1.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. (2)
The "medium swing", secondary reaction or intermediate reaction may last from
ten days to three months and generally retraces from 33% to 66% of the primary
price change since the previous medium swing or start of the main movement.
(3) The "short swing" or minor movement varies with opinion from hours to
a month or more. The three movements may be simultaneous, for instance, a daily
minor movement in a bearish secondary reaction in a bullish primary
movement.
2. Trends have three phases
Dow Theory
asserts that major market trends are composed of three phases: an accumulation
phase, a public participation 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 absorbing (releasing) stock that the market at large is supplying
(demanding). Eventually, the market catches on to these astute investors and a
rapid price change occurs (phase 2). This occurs when trend followers and
other technically oriented investors participate. This phase continues until
rampant speculation occurs. At this point, the astute investors begin to
distribute their holdings to the market (phase 3).
3.The stock market discounts all news
Stock prices
quickly incorporate new information as soon as it becomes available. Once news
is released, stock prices will change to reflect this new information. On this
point, Dow Theory agrees with one of the premises of the efficient market hypothesis.
4.
Stock market averages must confirm each other
In Dow's time, the US was a
growing industrial power. The US had population centers but factories were
scattered throughout the country. Factories had to ship their goods to market,
usually by rail. Dow's first stock averages were an index of industrial
(manufacturing) companies and rail companies. To Dow, a bull market in
industrials could not occur unless the railway average rallied as well, usually
first. According to this logic, if manufacturers' profits are rising, it follows
that they are producing more. If they produce more, then they have to ship more
goods to consumers. Hence, if an investor is looking for signs of health in
manufacturers, he or she should look at the performance of the companies that
ship the output of them to market, the railroads. The two averages should be
moving in the same direction. When the performance of the averages diverge, it
is a warning that change is in the air.
Both Barron's
Magazine and the Wall Street Journal still
publish the daily performance of the Dow Jones Transportation Index in chart
form. The index contains major railroads, shipping companies, and air freight
carriers in the US.
5. Trends are confirmed by volume
Dow believed that
volume confirmed price trends. When prices move on low volume, there could be
many different explanations why. An overly aggressive seller could be present
for example. But when price movements are accompanied by high volume, Dow
believed this represented the "true" market view. If many participants are
active in a particular security, and the price moves significantly in one
direction, Dow maintained that this was the direction in which the market
anticipated continued movement. To him, it was a signal that a trend is
developing.
6.Trends exist until definitive signals
prove that they have ended
Dow believed that trends existed despite "market
noise". Markets might temporarily move in the direction opposite to the trend,
but they will soon resume the prior move. The trend should be given the benefit
of the doubt during these reversals. Determining whether a reversal is the start
of a new trend or a temporary movement in the current trend is not easy. Dow
Theorists often disagree in this determination. Technical analysis tools attempt
to clarify this but they can be interpreted differently by different investors.
------(Back To Mainpage)
