Dow Theory
posted under
by ceecabolos
$ INTRODUCTION $
Charles Dow and his partner Edward Jones founded Dow Jones & Company in 1882. Most technicians and students of the markets concur that much of what we call technical analysis today has its origins in theories first proposed by Dow around the turn of the century. Dow published his ideas in a series of editorials he wrote for the Wall Street Journal. Most technicians today recognize and assimilate Dow's basic ideas, whether or not they recognize the source. Dow Theory still forms the cornerstone of the study of technical analysis, even in the face of today's sophisticated computer technology, and the proliferation of newer and supposedly better technical indicators.
On July 3, 1884, Dow published the first stock market average composed of the closing prices of eleven stocks: nine railroad companies and two manufacturing firms. Dow felt that these eleven stocks provided a good indication of the economic health of the country. In 1897, Dow determined that two separate indices would better represent that health, and created a 12 stock industrial index and a 20 stock rail index. By 1928 the industrial
index had grown to include 30 stocks, the number at which it stands today. The editors of The Wall Street Journal have updated the list numerous times in the ensuing years, adding a utility index in 1929. In 1984, the year that marked the one hundredth anniversary of Dow's first publication, the Market Technicians Association presented a Gorham-silver bowl to Dow Jones & Co. According to the MTA, the award recognized "the lasting contribution that Charles Dow made to the field of investment analysis. His index, the forerunner of what today is regarded as the leading barometer of stock market activity, remains a vital tool for market technicians 80 years after his death."
Unfortunately for us, Dow never wrote a book on his theory. Instead, he set down his ideas of stock market behavior in a series of editorials that The Wall Street Journal published around the turn of the century. In 1903, the year after Dow's death, S.A. Nelson compiled these essays into a book entitled The ABC of Stock Speculation. In that work, Nelson first coined the term "Dow's Theory." Richard Russell, who wrote the introduction to a 1978 reprint, compared Dow's contribution to stock market theory with Freud's contribution to psychiatry. In 1922, William Peter Hamilton (Dow's associate and successor at the Journal) categorized and published Dow's tenets in a book entitled The Stock Market Barometer. Robert Rhea developed the theory even further in the Dow Theory (New York: Barron's), published in 1932.
Dow applied his theoretical work to the stock market averages that he created; namely the Industrials and the Rails. However, most of his analytical ideas apply equally well to all market averages. This chapter will describe the six basic tenets of Dow Theory and will discuss how these ideas fit into a modern study of technical analysis. We will discuss the ramifications of these ideas in the chapters that follow.
BASIC TENETS
1. The Averages Discount Everything.
The sum and tendency of the transactions of the Stock Exchange represent the sum of all Wall Street's knowl‑
edge of the past, immediate and remote, applied to the discounting of the future. There is no need to add to the averages, as some statisticians do, elaborate compilations of commodity price index numbers, bank clearings, fluctuations in exchange, volume of domestic and foreign trades or anything else. Wall Street considers all these things (Hamilton, pp. 40-41).
Sound familiar? The idea that the markets reflect every possible knowable factor that affects overall supply and demand is one of the basic premises of technical theory, as was mentioned in Chapter 1. The theory applies to market averages, as well as it does to individual markets, and even makes allowances for "acts of God." While the markets cannot anticipate events such as earthquakes and various other natural calamities, they quickly discount such occurrences, and almost instantaneously assimilate their affects into the price action.
2. The Market Has Three Trends.
Before discussing how trends behave, we must clarify what Dow considered a trend. Dow defined an uptrend as a situation in which each successive rally closes higher than the previous rally high, and each successive rally low also closes higher than the previous rally low. In other words, an uptrend has a pattern of rising peaks and troughs. The opposite situation, with successively lower peaks and troughs, defines a downtrend. Dow's definition has withstood the test of time and still forms the cornerstone of trend analysis.
Dow believed that the laws of action and reaction apply to the markets just as they do to the physical universe. He wrote, "Records of trading show that in many cases when a stock reaches top it will have a moderate decline and then go back again to near the highest figures. If after such a move, the price again recedes, it is liable to decline some distance" (Nelson, page 43).
Dow considered a trend to have three parts, primary, secondary, and minor, which he compared to the tide, waves, and ripples of the sea. The primary trend represents the tide, the secondary or intermediate trend represents the waves that make up the tide, and the minor trends behave like ripples on the waves.
An observer can determine the direction of the tide by noting the highest point on the beach reached by successive waves. If each successive wave reaches further inland than the preceding one, the tide is flowing in. When the high point of each successive wave recedes, the tide has turned out and is ebbing. Unlike actual ocean tides, which last a matter of hours, Dow conceived of market tides as lasting for more than a year, and possibly for several years.
The secondary, or intermediate, trend represents corrections in the primary trend and usually lasts three weeks to three months. These intermediate corrections generally retrace between one-third and two-thirds of the previous trend movement and most frequently about half, or 50%, of the previous move.
According to Dow, the minor (or near term) trend usually lasts less than three weeks. This near term trend represents fluctuations in the intermediate trend. We will discuss trend concepts in greater detail in Chapter 4, "Basic Concepts of Trends," where you will see that we continue to use the same basic concepts and terminology today.
3. Major Trends Have Three Phases.
Dow focused his attention on primary or major trends, which he felt usually take place in three distinct phases: an accumulation phase, a public participation phase, and a distribution phase. The accumulation phase represents informed buying by the most astute investors. If the previous trend was down, then at this point these astute investors recognize that the market has assimilated all the so-called "bad" news. The public participation phase, where most technical trend-followers begin to participate, occurs when prices begin to advance rapidly and business news improves. The distribution phase takes place when newspapers begin to print increasingly bullish stories; when economic news is better than ever; and when speculative volume and public participation increase. During this last phase the same informed investors who began to "accumulate" near the bear market bottom (when no one else wanted to buy) begin to "distribute" before anyone else starts selling.
Students of Elliott Wave Theory will recognize this division of a major bull market into three distinct phases. R. N. Elliott elaborated upon Rhea's work in Dow Theory,to recognize that a bull market has three major, upward movements. In Chapter 13, "Elliott Wave Theory," we'll show the close similarity between Dow's three phases of a bull market and the five wave Elliott sequence.
4. The Averages Must Confirm Each Other.
Dow, in referring to the Industrial and Rail Averages, meant that no important bull or bear market signal could take place unless both averages gave the same signal, thus confirming each other. He felt that both averages must exceed a previous secondary peak to confirm the inception or continuation of a bull market. He did not believe that the signals had to occur simultaneously, but recognized that a shorter length of time between the two signals provided stronger confirmation. When the two averages diverged from one another, Dow assumed that the prior trend was still maintained. (Elliott Wave Theory only requires that signals be generated in a single average.) Chapter 6, "Continuation Patterns," will cover the key concepts of confirmation and divergence. (See Figures 2.1 and 2.2.)
5. $ Volume Must Confirm the Trend $.
Dow recognized volume as a secondary but important factor in confirming price signals. Simply stated, volume should expand or increase in the direction of the major trend. In a major uptrend, volume would then increase as prices move higher, and diminish as prices fall. In a downtrend, volume should increase as prices drop and diminish as they rally. Dow considered volume a secondary indicator. He based his actual buy and sell signals entirely on closing prices. In Chapter 7, "Volume and Open Interest," we'll cover the subject of volume and build on Dow's ideas. Today's sophisticated volume indicators help determine whether volume is increasing or falling off. Savvy traders then compare this information to price action to see if the two are confirming each other.
Charles Dow and his partner Edward Jones founded Dow Jones & Company in 1882. Most technicians and students of the markets concur that much of what we call technical analysis today has its origins in theories first proposed by Dow around the turn of the century. Dow published his ideas in a series of editorials he wrote for the Wall Street Journal. Most technicians today recognize and assimilate Dow's basic ideas, whether or not they recognize the source. Dow Theory still forms the cornerstone of the study of technical analysis, even in the face of today's sophisticated computer technology, and the proliferation of newer and supposedly better technical indicators.
On July 3, 1884, Dow published the first stock market average composed of the closing prices of eleven stocks: nine railroad companies and two manufacturing firms. Dow felt that these eleven stocks provided a good indication of the economic health of the country. In 1897, Dow determined that two separate indices would better represent that health, and created a 12 stock industrial index and a 20 stock rail index. By 1928 the industrial
index had grown to include 30 stocks, the number at which it stands today. The editors of The Wall Street Journal have updated the list numerous times in the ensuing years, adding a utility index in 1929. In 1984, the year that marked the one hundredth anniversary of Dow's first publication, the Market Technicians Association presented a Gorham-silver bowl to Dow Jones & Co. According to the MTA, the award recognized "the lasting contribution that Charles Dow made to the field of investment analysis. His index, the forerunner of what today is regarded as the leading barometer of stock market activity, remains a vital tool for market technicians 80 years after his death."
Unfortunately for us, Dow never wrote a book on his theory. Instead, he set down his ideas of stock market behavior in a series of editorials that The Wall Street Journal published around the turn of the century. In 1903, the year after Dow's death, S.A. Nelson compiled these essays into a book entitled The ABC of Stock Speculation. In that work, Nelson first coined the term "Dow's Theory." Richard Russell, who wrote the introduction to a 1978 reprint, compared Dow's contribution to stock market theory with Freud's contribution to psychiatry. In 1922, William Peter Hamilton (Dow's associate and successor at the Journal) categorized and published Dow's tenets in a book entitled The Stock Market Barometer. Robert Rhea developed the theory even further in the Dow Theory (New York: Barron's), published in 1932.
Dow applied his theoretical work to the stock market averages that he created; namely the Industrials and the Rails. However, most of his analytical ideas apply equally well to all market averages. This chapter will describe the six basic tenets of Dow Theory and will discuss how these ideas fit into a modern study of technical analysis. We will discuss the ramifications of these ideas in the chapters that follow.
BASIC TENETS
1. The Averages Discount Everything.
The sum and tendency of the transactions of the Stock Exchange represent the sum of all Wall Street's knowl‑
edge of the past, immediate and remote, applied to the discounting of the future. There is no need to add to the averages, as some statisticians do, elaborate compilations of commodity price index numbers, bank clearings, fluctuations in exchange, volume of domestic and foreign trades or anything else. Wall Street considers all these things (Hamilton, pp. 40-41).
Sound familiar? The idea that the markets reflect every possible knowable factor that affects overall supply and demand is one of the basic premises of technical theory, as was mentioned in Chapter 1. The theory applies to market averages, as well as it does to individual markets, and even makes allowances for "acts of God." While the markets cannot anticipate events such as earthquakes and various other natural calamities, they quickly discount such occurrences, and almost instantaneously assimilate their affects into the price action.
2. The Market Has Three Trends.
Before discussing how trends behave, we must clarify what Dow considered a trend. Dow defined an uptrend as a situation in which each successive rally closes higher than the previous rally high, and each successive rally low also closes higher than the previous rally low. In other words, an uptrend has a pattern of rising peaks and troughs. The opposite situation, with successively lower peaks and troughs, defines a downtrend. Dow's definition has withstood the test of time and still forms the cornerstone of trend analysis.
Dow believed that the laws of action and reaction apply to the markets just as they do to the physical universe. He wrote, "Records of trading show that in many cases when a stock reaches top it will have a moderate decline and then go back again to near the highest figures. If after such a move, the price again recedes, it is liable to decline some distance" (Nelson, page 43).
Dow considered a trend to have three parts, primary, secondary, and minor, which he compared to the tide, waves, and ripples of the sea. The primary trend represents the tide, the secondary or intermediate trend represents the waves that make up the tide, and the minor trends behave like ripples on the waves.
An observer can determine the direction of the tide by noting the highest point on the beach reached by successive waves. If each successive wave reaches further inland than the preceding one, the tide is flowing in. When the high point of each successive wave recedes, the tide has turned out and is ebbing. Unlike actual ocean tides, which last a matter of hours, Dow conceived of market tides as lasting for more than a year, and possibly for several years.
The secondary, or intermediate, trend represents corrections in the primary trend and usually lasts three weeks to three months. These intermediate corrections generally retrace between one-third and two-thirds of the previous trend movement and most frequently about half, or 50%, of the previous move.
According to Dow, the minor (or near term) trend usually lasts less than three weeks. This near term trend represents fluctuations in the intermediate trend. We will discuss trend concepts in greater detail in Chapter 4, "Basic Concepts of Trends," where you will see that we continue to use the same basic concepts and terminology today.
3. Major Trends Have Three Phases.
Dow focused his attention on primary or major trends, which he felt usually take place in three distinct phases: an accumulation phase, a public participation phase, and a distribution phase. The accumulation phase represents informed buying by the most astute investors. If the previous trend was down, then at this point these astute investors recognize that the market has assimilated all the so-called "bad" news. The public participation phase, where most technical trend-followers begin to participate, occurs when prices begin to advance rapidly and business news improves. The distribution phase takes place when newspapers begin to print increasingly bullish stories; when economic news is better than ever; and when speculative volume and public participation increase. During this last phase the same informed investors who began to "accumulate" near the bear market bottom (when no one else wanted to buy) begin to "distribute" before anyone else starts selling.
Students of Elliott Wave Theory will recognize this division of a major bull market into three distinct phases. R. N. Elliott elaborated upon Rhea's work in Dow Theory,to recognize that a bull market has three major, upward movements. In Chapter 13, "Elliott Wave Theory," we'll show the close similarity between Dow's three phases of a bull market and the five wave Elliott sequence.
4. The Averages Must Confirm Each Other.
Dow, in referring to the Industrial and Rail Averages, meant that no important bull or bear market signal could take place unless both averages gave the same signal, thus confirming each other. He felt that both averages must exceed a previous secondary peak to confirm the inception or continuation of a bull market. He did not believe that the signals had to occur simultaneously, but recognized that a shorter length of time between the two signals provided stronger confirmation. When the two averages diverged from one another, Dow assumed that the prior trend was still maintained. (Elliott Wave Theory only requires that signals be generated in a single average.) Chapter 6, "Continuation Patterns," will cover the key concepts of confirmation and divergence. (See Figures 2.1 and 2.2.)
5. $ Volume Must Confirm the Trend $.
Dow recognized volume as a secondary but important factor in confirming price signals. Simply stated, volume should expand or increase in the direction of the major trend. In a major uptrend, volume would then increase as prices move higher, and diminish as prices fall. In a downtrend, volume should increase as prices drop and diminish as they rally. Dow considered volume a secondary indicator. He based his actual buy and sell signals entirely on closing prices. In Chapter 7, "Volume and Open Interest," we'll cover the subject of volume and build on Dow's ideas. Today's sophisticated volume indicators help determine whether volume is increasing or falling off. Savvy traders then compare this information to price action to see if the two are confirming each other.
The most difficult task for a Dow theorist, or any trend-fol- lower for that matter, is being able to distinguish between a normal secondary correction in an existing trend and the first leg of a new trend in the opposite direction. Dow theorists often disagree as to when the market gives an actual reversal signal. Figures 2.3a and 2.3b show how this disagreement manifests itself.
Figures 2.3a and 2.3b illustrate two different market sce- narios. In Figure 2.3a, notice that the rally at point C is lower than the previous peak at A. Price then declines below point B. The presence of these two lower peaks and two lower troughs gives a clear-cut sell signal at the point where the low at B is bro- ken (point S). This reversal pattern is sometimes referred to as a "failure swing."
In Figure 2.3b, the rally top at C is higher than the previous peak at A. Then price declines below point B. Some Dow theorists would not consider the clear violation of support, at S1, to be a bona fide sell signal. They would point out that only lower lows exist in this case, but not lower highs. They would prefer to see a rally to point E which is lower than point C. Then they would look for another new low under point D. To them, S2 would represent the actual sell signal with two lower highs and two lower lows.
The reversal pattern shown in Figure 2.3b is referred to as a "nonfailure swing." A failure swing (shown in Figure 2.3a) is a much weaker pattern than the nonfailure swing in Figure 2.3b. Figures 2.4a and 2.4b show the same scenarios at a market bottom.
THE USE OF CLOSING PRICES AND THE PRESENCE OF LINES
Dow relied exclusively on closing prices. He believed that averages had to close higher than a previous peak or lower than a previous trough to have significance. Dow did not consider intraday penetrations valid.
When traders speak of lines in the averages, they are referring to horizontal patterns that sometimes occur on the charts. These sideways trading ranges usually play the role of corrective phases and are usually referred to as consolidations. In more modern terms, we might refer to such lateral patterns as "rectangles."
SOME CRITICISMS OF DOW THEORY
Dow Theory has done well over the years in identifying major bull and bear markets, but has not escaped criticism. On average, Dow Theory misses 20 to 25% of a move before generating a signal. Many traders consider this to be too late. A Dow Theory buy signal usually occurs in the second phase of an uptrend as price penetrates a previous intermediate peak. This is also, incidentally, about where most trend-following technical systems begin to identify and participate in existing trends.
In response to this criticism, traders must remember that Dow never intended to anticipate trends; rather he sought to recognize the emergence of major bull and bear markets and to capture the large middle portion of important market moves.
Available records suggest that Dow's Theory has performed that function reasonably well. From 1920 to 1975, Dow Theory signals captured 68% of the moves in the Industrial and Transportation Averages and 67% of those in the S&P 500 Composite Index (Source: Barron's). Those who criticize Dow Theory for failing to catch actual market tops and bottoms lack a basic understanding of the trend-following philosophy.
STOCKS AS ECONOMIC INDICATORS
Dow apparently never intended to use his theory to forecast the direction of the stock market. He felt its real value was to use stock market direction as a barometric reading of general business conditions. We can only marvel at Dow's vision and genius. In addition to formulating a great deal of today's price forecasting methodology, he was among the first to recognize the usefulness of stock market averages as a leading economic indicator.
DOW THEORY APPLIED TO FUTURES TRADING
Dow's work considered the behavior of stock averages. While most of that original work has significant application to commodity futures, there are some important distinctions between stock and futures trading. For one thing, Dow assumed that most investors follow only the major trends and would use intermediate corrections for timing purposes only. Dow considered the minor or near term trends to be unimportant. Obviously, this is not the case in futures trading in which most traders who follow trends trade the intermediate instead of the major trend. These traders must pay a great deal of attention to minor swings for timing purposes. If a futures trader expected an intermediate uptrend to last for a couple of months, he or she would look for short term dips to signal purchases. In an intermediate downtrend, the trader would use minor bounces to signal short sales. The minor trend, therefore, becomes extremely important in futures trading.
Figures 2.3a and 2.3b illustrate two different market sce- narios. In Figure 2.3a, notice that the rally at point C is lower than the previous peak at A. Price then declines below point B. The presence of these two lower peaks and two lower troughs gives a clear-cut sell signal at the point where the low at B is bro- ken (point S). This reversal pattern is sometimes referred to as a "failure swing."
In Figure 2.3b, the rally top at C is higher than the previous peak at A. Then price declines below point B. Some Dow theorists would not consider the clear violation of support, at S1, to be a bona fide sell signal. They would point out that only lower lows exist in this case, but not lower highs. They would prefer to see a rally to point E which is lower than point C. Then they would look for another new low under point D. To them, S2 would represent the actual sell signal with two lower highs and two lower lows.
The reversal pattern shown in Figure 2.3b is referred to as a "nonfailure swing." A failure swing (shown in Figure 2.3a) is a much weaker pattern than the nonfailure swing in Figure 2.3b. Figures 2.4a and 2.4b show the same scenarios at a market bottom.
THE USE OF CLOSING PRICES AND THE PRESENCE OF LINES
Dow relied exclusively on closing prices. He believed that averages had to close higher than a previous peak or lower than a previous trough to have significance. Dow did not consider intraday penetrations valid.
When traders speak of lines in the averages, they are referring to horizontal patterns that sometimes occur on the charts. These sideways trading ranges usually play the role of corrective phases and are usually referred to as consolidations. In more modern terms, we might refer to such lateral patterns as "rectangles."
SOME CRITICISMS OF DOW THEORY
Dow Theory has done well over the years in identifying major bull and bear markets, but has not escaped criticism. On average, Dow Theory misses 20 to 25% of a move before generating a signal. Many traders consider this to be too late. A Dow Theory buy signal usually occurs in the second phase of an uptrend as price penetrates a previous intermediate peak. This is also, incidentally, about where most trend-following technical systems begin to identify and participate in existing trends.
In response to this criticism, traders must remember that Dow never intended to anticipate trends; rather he sought to recognize the emergence of major bull and bear markets and to capture the large middle portion of important market moves.
Available records suggest that Dow's Theory has performed that function reasonably well. From 1920 to 1975, Dow Theory signals captured 68% of the moves in the Industrial and Transportation Averages and 67% of those in the S&P 500 Composite Index (Source: Barron's). Those who criticize Dow Theory for failing to catch actual market tops and bottoms lack a basic understanding of the trend-following philosophy.
STOCKS AS ECONOMIC INDICATORS
Dow apparently never intended to use his theory to forecast the direction of the stock market. He felt its real value was to use stock market direction as a barometric reading of general business conditions. We can only marvel at Dow's vision and genius. In addition to formulating a great deal of today's price forecasting methodology, he was among the first to recognize the usefulness of stock market averages as a leading economic indicator.
DOW THEORY APPLIED TO FUTURES TRADING
Dow's work considered the behavior of stock averages. While most of that original work has significant application to commodity futures, there are some important distinctions between stock and futures trading. For one thing, Dow assumed that most investors follow only the major trends and would use intermediate corrections for timing purposes only. Dow considered the minor or near term trends to be unimportant. Obviously, this is not the case in futures trading in which most traders who follow trends trade the intermediate instead of the major trend. These traders must pay a great deal of attention to minor swings for timing purposes. If a futures trader expected an intermediate uptrend to last for a couple of months, he or she would look for short term dips to signal purchases. In an intermediate downtrend, the trader would use minor bounces to signal short sales. The minor trend, therefore, becomes extremely important in futures trading.
NEW WAYS TO TRADE THEDOW AVERAGESFor the first 100 years of its existence, the Dow Jones Industrial Average could only be used as a market indicator. That all changed on October 6, 1997 when futures and options began trading on Dow's venerable average for the first time. The Chicago Board of Trade launched a futures contract on the Dow Jones Industrial Average, while options on the Dow (symbol: DJX) started trading at the Chicago Board Options Exchange. In addition, options were also launched on the Dow Jones Transportation Average (symbol: DJTA) and the Dow Jones Utility Index (symbol: DJUA). In January 1998, the American Stock Exchange started trading the Diamonds Trust, a unit investment trust that mimics the 30 Dow industrials. In addition, two mutual funds were offered based on the 30 Dow benchmark. Mr. Dow would probably be happy to know that, a century after their creation, it would now be possible to trade his Dow averages, and actually put his Dow Theory into practice
CONCLUSION
This chapter presented a relatively quick review of the more important aspects of the Dow Theory. It will become clear, as you continue through this book, that an understanding and appreciation of Dow Theory provides a solid foundation for any study of technical analysis. Much of what is discussed in the following chapters represents some adaptation of Dow's original theory. The standard definition of a trend, the classification of a trend into three categories and phases, the principles of confirmation and divergence, the interpretation of volume, and the use of percentage retracements (to name a few), all derive, in one way or another, from Dow Theory.
In addition to the sources already cited in this chapter, an excellent review of the principles of Dow Theory can be found in Technical Analysis of Stock Trends (Edwards & Magee).
This chapter presented a relatively quick review of the more important aspects of the Dow Theory. It will become clear, as you continue through this book, that an understanding and appreciation of Dow Theory provides a solid foundation for any study of technical analysis. Much of what is discussed in the following chapters represents some adaptation of Dow's original theory. The standard definition of a trend, the classification of a trend into three categories and phases, the principles of confirmation and divergence, the interpretation of volume, and the use of percentage retracements (to name a few), all derive, in one way or another, from Dow Theory.
In addition to the sources already cited in this chapter, an excellent review of the principles of Dow Theory can be found in Technical Analysis of Stock Trends (Edwards & Magee).
