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
Markets fluctuate in more than one time frame at the
same time:
Nothing is more certain than that the market has
three well defined movements 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
Look out for these 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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