How To Use Dow Theory For Profits

Many investors are fixated on learning the newest stock market analysis techniques rather than studying original yet time proven investing tools.  The reason for this is the fact that analysis methods often become outdated due to technological or market changes.  However, there is an ancient stock market analysis method that continues to work even in today’s hyper-competitive marketplace.

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In fact, this process forms the basis of technical analysis.  Understanding this process will build a strong foundation for you to build upon in your investing journey.

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I am referencing Dow Theory, a concept credited to Charles Dow and advanced by William Hamilton, Robert Rhea, and George Schaefer.

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Dow Theory is a methodology to determine the actual trend of the stock market.

Trend means the overall directional movement, as shown on price charts, as either up or down.

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Uptrends are well-defined as a series of higher highs and higher lows.

Downtrends are a series lower highs and lower lows.

Classical technical analysis teaches that trends are valid until a change of trend is proven to have taken place.  Dow Theory refines the concept of trend by breaking it into three distinct movements:

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  1. The Primary Movement

This is the long-term trend.  The Primary Movement can last from a few months to multiple years.  It can be an uptrend or a downtrend, however according to Dow theorist, William Hamilton, it’s impossible to forecast either the strength or length of the Primary Movement. Hamilton believed that success in the market was keyed into the ability to identify the Primary Movement, invest/trade in its direction, and stick with the trade until proven wrong.   This struck me as being uncannily similar to the modern day “Trend Followers.”

 

  1. The Secondary Movement

This is what is known as a pull back or retracement in a bull market.  In bear markets, it’s called a reactionary rally or bounce.

The secondary movement can last from 10 days to several months and retraces the Primary Movement by an average of 50%.

3. The Short Swing or Minor Movement

If you are a day trader or short term swing trader, this is the price movement that you trade.  It can last from intraday to several days but does not convert into a Secondary Movement until two weeks.

Dow Theory teaches that there are 3 phases within every major market trend.  In a bull trend, these stages are:

1. The Accumulation Phase

Dow Theory believes that this is the time where the big money, insiders are quietly buying shares against the general opinion of the public.  They are using their inside knowledge of what may happen to buy stock at what looks like a poor time to buy to the general public.  This enables these insiders to accumulate shares without affecting the market much, as the public is readily selling to them.

2. The Big Move  

The big move occurs when the market has already started to trend Technical traders start buying as their technical indicators begin to trigger buy signals.  The trend followers also catch on during this phase, pushing the market even higher.

3. Public Participation/Excess

This is the final phase of the bull market.  Widespread public participation in the market is what signals this phase. Everyone from the shoeshine boy to the CEO are stock investors.  You start getting stock tips from everyone and cocktail chatter is focused on the market.  Astute investors know that the top is very close when signs of this market phase begin to surface.

The opposite of a bull market is a bear market.  Here are the market phases to look for during bear markets.

1. Distribution—

Distribution is the opposite of the accumulation phase in a bull market.

It occurs when the smart/big money begins to think that the bull market is over, although the public still believes the uptrend will never end.

They begin to sell stock to the public who readily buys all that can be thrown at them, oblivious to the obvious fact that the market is topping.

The market will start to go down, but most analysts and traders will refuse to believe the bull trend is over.  This strong belief in the longevity of the bull trend will cause new money to come into the market during these times, sometimes a lot of it.

This new influx will result in sharp, severe rallies that will bring in even more capital into the market as it seems that the bull trend has resumed. This move will not take out the previous highs and is merely a reactionary rally, then phase 2 begins.

  1. The Big Down Move

The serious selling begins after the reactionary rally fails.

The public starts to get worried and begins to sell stocks, pushing the market down even faster.

Bad news begins to sweep the news wires, what was once a rosy picture begins to be filled with negativity and despair, leading us to the next and final phase of the bear trend.

3. Despair

Once people start to believe that the market will stay down forever, a new uptrend will begin and the whole cycle starts again.

The Technical Confirmation

The next primary concept in Dow Theory is that 2 Averages must confirm the trend together.

Prior to the Transportation index, Charles Dow used the Railroad Index to confirm the trend in the DJIA.

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Today, Dow theorists use the Transportation Index to confirm the trend in the DJIA.

The theory behind this confirmation is that the United States is connected via the transportation sector or rail sector in Mr. Dow’s day, therefore the transportation index should reflect booming or busting economic times.

If one of these averages makes a new high or low, the other one needs to confirm soon after for a Dow Theory buy/sell signal to be valid.

Don’t Forget Volume

Volume is the final aspect of Dow theory.  Charles Hamilton believed that volume is necessary, but the price has the last word in trend determination.  His idea was that volume should increase in the direction of the primary trend and decrease on corrections.  Dow theory teaches that volume is a way to judge the strength of a trend, not the direction.  However, extremely high volume relative volume readings can signal a reversal.  Technical Analysts refer to these occurrences as “blow off tops”.

I like using Dow Theory as a confirmation tool to determine if we are in or approaching a bullish or bearish period in the stock market.  The old saying that a rising tide lifts all boats is very apropos for investors.

The Issues With Dow Theory

The big question whenever traders and Technical Analyst’s meet is whether or not Dow Theory is still valid in today’s market.

There are compelling arguments on both sides.

One of the primary criticisms of Dow Theory is that it’s too conservative in identifying trends.  This means that the direction is often finished or almost finished by the time Dow Theory gives a signal.

Another criticism is that the markets have changed since Dow’s time relying much more on the knowledge economy and less on the industrial economy in that the transportation confirmation factor is no longer relevant.

Regardless of your point of view, Dow Theory is one of the building blocks to modern day Technical Analysis thus should be studied by every market aficionado.