Charles Dow viewed the stock market as an indicator of business activity. He rationalized that if the Industrial companies were prosperous then the Railroad companies which transported their manufactured goods would also be prosperous. Conversely if Industrial companies were struggling with revenue then there would be less goods to be transported and thus the Railroad companies would also be faced with a reduction in revenue.
Bull Market Reversal
Charles Dow’s rationalized that if the Industrial stocks were in a bull market then the Railroad stocks would also be in a bull market. He used an average of the stock prices and noted that the Averages tended to fluctuate about somewhat in a bull market and minor corrections were common place.
The basis for Charles Dow’s theory is that for a bull market to end, the Industrial Average and the Railroad Average would both end their bull market run. His theory provides a means for determining the likelihood that both Averages have ended their bull market run.
Note: The Railroad Averages is nowadays referred to as the Transport Averages.
Figure 1. below shows Charles Dow’s method for determining when an Average has ended its bull market run.
Figure 1. Dow Theory Bull Market Reversal
The method Charles Dow used to determine the end of an uptrend as shown in Figure 1. above is commonly used in modern technical analysis by market participants, often without even realizing that it was actually Charles Dow that first presented this method for explaining the pricing behavior of markets..
The idea behind Dow Theory is straight forward. The Average makes a Relative High and sells-off to make a Relative low and then rallies to make another Relative High and finally sells down through the Relative Low. A trend change is confirmed when the Average trades below the Relative Low.
In Dow Theory both the Industrial Average and the Railroad Average must signal a trend reversal. The signals do not need to be on the same day. The 3% minimum is set in the Dow Theory so that the rally is meaningful and not just some minor daily fluctuations.
A common variation to the chart pattern shown if Figure 1. for a bull market reversal is shown below in Figure 2.
Figure 2. Variation of Dow Theory Bull Market Reversal
From Figure 2. above, the Average made a new higher second Relative High but the reversal confirmation is still the same as the index must trade below the Relative Low to confirm the reversal.
Bear Market Reversal
In Dow Theory, for a bear market to end, both the Industrial Average and the Railroad Average must signal a trend reversal.
Figure 3. below shows Charles Dow’s method for determining when an Average has ended its bear market run.
Figure 3. Dow Theory Bear Market Reversal
From Figure 3. above, the Average makes a Relative Low and rallies to make a Relative High and then sells down to make a second Relative Low. A trend change is confirmed when the Average trades above the Relative High.
A common variation to the chart pattern shown if Figure 3. for a bear market reversal is shown below in Figure 4.
Figure 4. Variation of Dow Theory Bear Market Reversal
From Figure 4. above, the Average made a new lower second Relative Low but the reversal confirmation is still the same as the index must trade above the Relative High to confirm the reversal.
Dow Theorems
The above four charts graphically display the basis of the Dow Theory. Of course the Railroad Average is now referred to as the Transportation Average since truck transport and airline stocks are now included in the Average which were not present in the days of Charles Dow.
The Dow Theory goes further into detail regarding trends and presented some hypotheses.
The hypotheses put forward in Dow Theory are:
Dow Theory Hypotheses:
- Manipulation: Both Dow and Hamilton noted that the markets were frequently the subject of price manipulation in the short-term. Large account traders and Specialists (designated market makers) could move prices to their benefit. However, the long-term trend could not be manipulated as business activity would determine the direction.
- Averages Discount Everything: Dow Theory notes that the Market has already factored in all information, knowledge and expectations. The basis is that the market is forward looking and any new information is quickly absorbed by the market and reflected in the averages with no long-term lasting effects.
- The theory is not infallible: Both Dow and Hamilton noted that the work of Charles Dow was a guide to market behavior and not a means of beating the market. The primary purpose of Dow Theory is to allow the stock investor to hop on board a new bull market closer to the start and ride the bull market for as long as it lasts and exit their positions (or at least reduce their holdings) when the bear market takes hold.
The trending nature of the Averages was characterized in Dow Theory which presented the notion that prices did not move in straight lines. What is known as Relative Highs and Relative Lows were actually part of Dow Theory.
In Dow Theory, the Averages move through Peaks (Relative Highs) and Troughs (Relative Lows).
Dow Theory also characterizes trends as three types of movements, the Primary movement, the Secondary reaction and the Daily fluctuations.
Dow Theory Movements:
- The Primary movement is the broad general trend direction such as an up-trending bull market or a down-trending bear market. This is the trend leading up to the Relative Highs in Figures 1 & 2 and the lead up to the Relative Lows in Figures 3 & 4. In addition, Dow Theory does not forecast the extent or duration of the primary movement. The theory is only intended to identify when a primary movement has reversed.
- The Secondary reactions are the market corrections that go against the primary trend. For a bull market, the Secondary reaction is generally a short-term correction where the Averages are declining but may also be an intermediate-term trend. These are the short-term trends after the first Relative High in Figures 1 & 2 and after the first Relative Low in Figures 3 & 4.
- The Daily fluctuations in Dow Theory are basically fluctuations within the short-term swings which Dow Theory considers unimportant. Dow Theory only considers the trends important.
The Dow Theory Applied
The Dow Theory outlined above is illustrated with the actual market reversal which ended the 2002-2007 bull market and started a bear market which was labeled the 2008 financial crises.
Chart 1. Dow Theory signals for Industrial Average
Chart by stockcharts.com
Referring to Chart 1. the Primary movement can be determined more readily with the aid of a 12-month (260-day) simple moving average. Bull markets commonly have a 12-month moving average that slopes upwards. As can be seen on Chart 1. the 12-month moving average is sloping upwards thus confirming that the Primary movement is a bull market trend.
The Secondary reactions can be located with a 20-day simple moving average. This facilitates in locating the relative highs and lows for the short-term corrections.
As Chart 1. above shows the Dow Industrial average trades below its RL in November to signal a reversal but then trades back up again. The Dow Industrial average then trades back down below its RL again in January 2008 and this time remains below its RL.
To give a Dow Theory reversal signal the Dow Transport average must also trade below its RL. The trading action of the Dow Transport average is shown below in Chart 2.
Chart 2. Dow Theory signals for Transport Average
Chart by stockcharts.com
Chart 2. above shows that both times when the Dow Industrial average traded below its RL the Dow Transport average also traded its RL which confirmed the Dow Theory signal.
It is quite common for the Dow Industrial average to give a signal by trading below its RL only to trade back up again and then trade back down once more.
As a general rule the Dow Theory reversal signal remains in effect as long as the Dow Industrial average remains below its RL. So in Chart 1. the signal remains in effect from January 2008.
The Dow Transport average only needs to trade below its RL to give the Dow Theory signal but after that it can trade above its RL and the Dow Theory signal still remains in effect (as is shown in Chart 2).
Summary
While Dow Theory originated over 100 years ago, the basic principles that comprise the theory are as sound today as they were back then. Granted the Railroads Average now includes other transport based stocks but they nevertheless still transport goods from the Industrial businesses. Nor has anything changed with the trending nature of stocks; they still have long-term, intermediate-term and short-term trends.
Any theory has its fair share of critics and Dow Theory is no different. Dow Theory at least points out that it is not infallible and the theory even states that it is not intended to outperform the market. Having said that, there are still some issues with the theory, in particular defining the Secondary reaction and the 3% rule can lead to extremely late signals and even missed signals. The following article on The Dow Theory for Today discusses the shortfalls of the theory and how the theory can be altered slightly so that its application is more suitable for today’s markets.