Dow Theory

Charles H. Dow was the founder of the Dow-Jones financial news service, and the founder and 1st editor of the Wall Street Journal. Charles Dow is considered the founder of technical analysis because he created the 1st stock market index, the Dow Jones Industrial Average (DJIA), and sporadically wrote editorials about stock price movements before his early death at 52 in 1902. However, he never codified his thoughts into a coherent theory.

William Peter Hamilton succeeded Charles Dow as the editor of the Wall Street Journal and expounded on the basic tenets of the Dow Theory. However, it was Robert Rhea who refined the ideas into 3 basic tenets that served as the foundation of the Dow Theory:

  1. The primary trend is inviolate.
    1. While the secondary and minor trends of the market could possibly be manipulated by some traders, the primary trend was the result of long-term economic cycles that could not be significantly affected by a few traders.
  2. The averages discount everything.
    1. One meaning of discount as a verb is to anticipate something that may have an impact on something being considered and making adjustments to it. Here the word is being used to say that stock prices already reflect all that is known about it or anything related to it by all the market participants trading the stock at a particular time. Stock prices are set by the equilibrium of supply and demand, and supply and demand is the result of all influences that may affect prices, including each individual trader's knowledge of present conditions and expectations of the future.
  3. The Dow Theory is not infallible.
    1. Because the stock market and stock prices are the result of many complex interactions, forecasts can never be 100% accurate or even close to it. But by studying the market with an emotional detachment, one can anticipate market moves and make profits greater than losses.

Primary, Secondary, and Minor Trends

The Dow Theory posits that there are 3 concomitant trends in the market: the primary trend, the secondary trend, and the minor trends.

Primary Trend

The primary trend is the overall direction of the market and is the longest lasting trend. Often, the trend lasts for years. It moves up and down with the economic cycles; hence, it is the most predictable. The primary trend is also always an uptrend or a downtrend; it is never a sideways trend. A sideways trend is secondary and temporary.

The primary trend in a bull market is characterized by 3 phases. In the 1st phase, buyers are buying because of the cheap prices that were the result of the ending bear market.

The 2nd phase begins when the economy starts to prosper and as it does, companies benefit and start reporting increased earnings. This, in turn, entices more stock buying, raising the market higher.

As the market rises ever higher, even people who have never traded before start to take notice. Speculation constitutes the 3rd phase. They hear the riches that their friends are making, and, they, too, start buying, propelling the market ever higher—much higher than can be justified by fundamentals—until the market can go no higher, because everyone has invested; everyone has borrowed to the hilt to profit from the rising market.

The primary trend in a bear market starts as markets start declining. In the 1st phase of a bear market, people start to get anxious, especially those who bought at the top and all those who borrowed money to make a big profit. They start selling, the market declines further. They suffer losses so they cut back on spending.

In the 2nd phase of the bear market, selling is increased because businesses start to suffer—decreased earnings, losses from business investments. As these negative reports start coming out, people start selling even more, and the market declines even further.

Finally, in the 3rd phase of the market, the market has declined so much that people sell out of despair, or they are forced to liquidate their leveraged holdings, causing a further decline in price. Sounds like the Credit Crisis of 2008 and 2009!

Secondary Trend

The primary trend is the general direction for prices, but it is not the only direction. The market will often go in the opposite direction—a retracement—for a period of several weeks to possibly several months as traders take profits when there is little news to propel the market higher. This is the secondary trend, which is a price movement in the opposite direction of the primary trend and over a shorter duration. Because of its unpredictability and shorter time frame, Dow believed it was risky to try to profit from the secondary trend.

Minor Trend

The minor trends of the market are the daily and weekly fluctuations that result from the imbalance of supply and demand over short periods of time. Since the instantaneous supply-demand equilibrium is impossible to predict, Dow theorists considered minor trend plays as being too risky.

Confirmation

Charles Dow introduced another concept central to technical analysis—confirmation. Dow had created another index of railroads, which eventually become the Dow Jones Transportation Average. Railroads transported the bulk of materials in his day; hence, the state of the economy could be gauged by the state of the railroad industry. If the railroad industry was doing well, then business in general was doing well. Increased transportation meant not only increased business for railroads, but also for most other businesses; otherwise, there would be fewer transported goods. This comports with modern economics—general economics affects all businesses, and, therefore, the financial markets.

So, if both indexes reversed trend, then this was a good confirmation that the primary trend was reversing and that the reversal was not just a secondary or minor trend.

Volume as Confirmation

Another factor considered by Dow Theorists was volume. When the volume was declining on higher prices and increasing on declining prices, this was an indication that an uptrend may be reversing. Conversely, when volume was less on price declines in a downtrend, and greater in market rallies, this could serve as a confirmation that a bear market was ending, and a bull market was beginning.

However, Dow Theorists did not consider volume as important as the primary trend or confirmation by the 2 Dow averages, because volume was relative and hard to compare from period to period, especially in the early 1900's.

Conclusions

Charles Dow believed that the best way to make money in the markets was to ride the primary trend. Secondary and minor trends were considered too unpredictable. Too much money would be lost because of transaction costs and errors in judgment. He used confirmation of his 2 averages as a means to verify that a new primary trend was in place, which makes sense, of course, since the primary trend is powered by the economic trend, which affects most businesses.

The main criticism of the Dow Theory was that trends were lagging indicators and that by the time the primary trend was confirmed, the primary trend was already in place, and the investor lost part of that move. But on the other hand, the investor would not have lost if the trend reversal was only a secondary or minor trend.

Modern technical analysis strives to make money in any kind of market, whether it is trending up, down, or sideways, and in any time frame, including intraday. However, periodically I come across articles about day traders, for instance, and read about how most of them lose more than they earn.

After the elapse of more than a century since Charles Dow's death, his basic ideas still remain true. The easiest way to make money in the markets is to follow the primary trend, for that is the easiest trend to see and to forecast. There may be traders who make a lot of money on shorter trends, but most of them probably do not make enough to just the amount of time they are spending watching the markets or the anxiety they feel as the markets twist and turn on a whim, and those who are most successful may be so because of luck.

News

Dogs of the Dow Stock Strategy

Sep 8, 2006 - The Dogs of the Dow strategy is to buy the 10 blue chip stocks of the Dow Jones Industrial Average (DJIA) that have the highest dividend yield (=dividend/stock price), and holding them for about a year, then repeat, if desired. Often, these are stocks that have suffered price declines in the previous year, thus raising their dividend yields. The Dogs have done well this year, with total returns of 21% versus 7.9% for the DJIA. Last year, however, the Dogs lost 5% versus a gain of 1.7% for the DJIA. This strategy would probably work better if some analysis was done to determine why the Dogs have become dogs, and is their status going to change. Such an analysis would probably involve changing the time frame as well. Nonetheless, since they do pay dividends, at least the shareholder is getting paid while holding onto the stocks, and, of course, there is simplicity in following the naive strategy that may work more often than not.

WSJ.com - 'Dogs of the Dow' Strategy Proves You Aren't Barking Up Wrong Tree