THE DOW THEORY

@Victor Sperandeo. Trader Vic--Methods of a Wall Street Master
 

People are not machines ordered and structured by mathematics; they are being of Choice. And people are the Markets. Literally millions of market decisions are made each day, and the results of each one has its effect on Price movements.

 

You can never predict with absolutely Certainty how the collection of individuals that make up the markets will react to events nor what new conditions will arise. BUT there is Order to the Chaos, and it is the speculator's job to find it.

 

Market forecasting is a matter of probabilities; the risk of being wrong is always present. The best you can do is minimize risk by maximizing knowledgeby understanding the original conditions that give rise to probable future events. That way, it is possible to keep the odds in your favor and to be right more often than not in making market decisions. The first step in obtaining this knowledge is to find a way to monitor the pulse of market behavior.

 

Dow Theory, if properly understood, is one tool to be used as an aid in forecasting future events within the bounds of probability. It won't tell you the causes of change, but it will indicate the symptoms that lead to change. It won't tell you exactly what is going to happen, but it will give you a general overview of what is likely to happen.

 

Properly considered, Dow Theory provides the key starting point with which to analyze stock market behavior.


THE "HYPOTHESES" OF DOW THEORY

Hypothesis number 1


Manipulation: Manipulation is possible in the day to day movement of the averages, and secondary reactions are subject to such an influence to a more limited degree, but the primary trend can never be manipulated.

 

The essence of this observation is that the stock market is too diverse and too complex for one person or group to affect prices in the market as a whole for a sustained period of time.

 

Hypothesis number 2
The Averages Discount Everything: The fluctuations of the daily closing prices of the Dow-Jones rail and industrial averages afford a composite index of all hopes, disappointments, and knowledge of everyone who knows anything of financial matters, and for that reason the effects of coming events (excluding acts of God) are always properly anticipated in their movement. The averages quickly appraise such calamities as fires and earthquakes.

 

Hypothesis number 3
The Theory Is Not Infallible: The Dow Theory is not an infallible system for beating the market. Its successful use as an aid in speculation requires serious study, and the summing up of evidence must be impartial. The wish must never be allowed to father the thought.

 

The idea that everyone receives all significant information simultaneously is absurd because everyone doesn't agree on what is "significant." Even if everyone did receive exactly the same information simultaneously, they would respond to it according to their own particular circumstances and preferences. If everyone knew exactly the same things and responded the same way, then there would be no market! You must always remember that markets exist to facilitate exchange, and exchange is the result of differences in value preferences and differences in judgments.

 

The primary task of the speculator is to identify the major active factors which drive or will change the predominant trend of market participants' opinions, and the market indices provide the best tool with which to correlate events with public opinion on financial matters.

THE "THEOREMS" OF DOW THEORY

 

Theorem number 1


Dow's Three Movements: There are three movements of the averages, all of which may be in progress at one and the same time.

  • The first, and most important, is the primary trend: the broad upward or downward movements know as bull or bear markets, which may be of several years duration.

  • The second, and most deceptive movement, is the secondary reaction: an important decline in a primary bull market or a rally in a primary bear market. These reactions usually last from three weeks to as many months.

  • The third, and usually unimportant, movement is the daily fluctuation

 

There are three trends in the stock averages and in any market: the short-term trend, lasting from days to weeks; the intermediate-term trend, lasting from weeks to months; and the long-term trend, lasting from months to years. All three trends are active all the time and may be moving in opposing directions.

 

Theorem number 2


Primary Movements: The primary movement is the broad basic trend generally known as a bull or bear markets extending over periods which have varied from less than a year to several years. The correct determination of the direction of this movement is the most important factor in successful speculation. There is no known method of forecasting the extent or duration of a primary movement.

 

Knowing the long-term trend, or primary movement, is the essential minimum requirement for successful speculation and investment.

 

Theorem number 3


Primary Bear Markets: A primary bear market is the long downward movement interrupted by important rallies. It is caused by various economic ills and does not terminate until stock prices have thoroughly discounted the worst that is apt to occur.

There are 3 principal phases of a bear market:

  • the first represents the abandonment of hopes upon which stocks were purchased at inflated prices

    • fundamental valuations will still be high

    • interest rates peak

    • the economy is still strong

    • public see a buying opportunity

    • volume falls, buying is done

    • market may ignore good news

    • there may be some shock news

    • the public may also panic, triggering a crash

    • floats fail and are then abandoned

  • the second reflects selling due to decreased business and earnings

    • earnings decreases announced

    • market ignores good news

    • former market leaders may fail

    • a recession begins

    • sharp rallies leading to further falls

    • few new floats

    • the public lose interest

  • the third is caused by distress selling of sound securities, regardless of their value, by those who must find a cash market for a least a portion of their assets

    • significant undervaluation

    • unemployment peaks

    • many bankruptcies and failures

    • bad news is discounted

    • market rarely in the news

    • low public interest and participation

    • stock price charts show accumulation

 

Theorem number 4

 

Primary Bull Markets: A primary bull market is a broad upward movement, interrupted by secondary reactions, and averaging longer than two years. During this time, stock prices advance because of a demand created by both investment and speculative buying caused by improving business conditions and increased speculative activity.

 

 

There are 3 phases of a bull period:

  • the first is represented by reviving confidence in the future of business

    • reviving confidence

    • all news is bad

    • based on anticipation

    • public absent from the market

    • market may ignore bad news

    • thought to be a bear market rally

    • disbelief turns to FOMO

    • fundamental undervaluation

  • the second is the response of stock prices to the known improvement in corporations earnings

    • earnings increases emerge

    • good news announced

    • employment picks up

    • longest and safest phase

    • new companies floated

    • significant corrections end higher

    • fundamental values normal

    • sector rotation

  • the third is the period when speculation is rampant and inflation [of stock prices] apparent-a period when stocks are advanced on hopes and expectations

    • significant fundamental overvaluation

    • interest rates relatively high

    • increased price volatility

    • many new floats and capital raisings

    • public enter the market, also day traders

    • media coverage and interest increases

    • market regulation relaxed

    • new paradigm theories advanced

    • market driven by few stocks

Theorem number 5

 

Secondary Reactions: a secondary reaction is considered to be an important decline in a bull market or advance in a bear market, usually lasting from three weeks to as many months, during which intervals the price movement generally retraces from 33% to 66% of the primary price change since the termination of the last preceding secondary reaction. These reactions are frequently erroneously assumed to represent a change of primary trend, because obviously the first stage of a bull market must always coincide with a movement which might have proved to have been merely a secondary reaction in a bear market, the contra being true after the peak has been attained in a bull market.

Judging when an intermediate move is a correction requires looking at volume relationships, statistical data on the historical probabilities of it being a correction, the general attitude of market participants, the financial conditions of different companies, the state of the economy, the policies of the Federal Reserve Board, and many other factors. The classification is somewhat subjective, but it is very important to be accurate. Quite often, it is difficult or impossible to tell the difference between a secondary reaction and the ending of a primary movement.

 

Secondary reactions should not be confused with minor reactions that occur frequently within primary and secondary price movements. Minor reactions move in opposition to the intermediate trend and last less than two weeks (14 calendar days) 98.7% of the time. They have virtually no impact on the intermediate or long-term trends.

 

In a bull market, the secondary correction is the safety valve which relieves the pressure of an overbought market. In a bear market, the secondary reaction is additional fire in the furnace to build up pressure that is lacking from an oversold condition.

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