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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