Dow Theory
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Dow Theory

Dow Theory; Introduction

However, Dow theory is from 100 years ago, still it is a reliable theory in today’s technology-driven markets. Dow theory not only analysis the technical performance of prices, but also introduces market psychology. These days, many of Dow and Hamilton theories are Wall Street principles. If one takes a look at “Dow Theory” written by Robert Rhae, could realize that the behavior of the market in todays day is similar to the behavior of the past 100 years. Dow can be used in any market as well as cryptocurrency market.

 

Charles Dow was the editor and the shareholder of Wall Street Journal. Since the end of 19th century until his death in 1902, he expressed his ideas on manufacturing and transportation industry. After that, from 1902 to 1929, Hamilton started to define Dow’s ideas in the form of articles and published them in Wall Street Journal. Hamilton also published a book named “The Stock Market Barometer” in 1922. In this book he explained Dow’s theory. It was in 1932 that Robert Rhae published a book named “Dow Theory”. In this book, he explained and studied 252 articles from Dow and Hamilton.

 

Dow Theory; Assumptions

The assumptions, which are mentioned below are essential to understand the Dow theory. Therefore, before we go deep into this topic, it is required that ones become familiar with these assumptions.

Influence

The first assumption is that it’s impossible to influence and manipulate the main market trend. When there is high volume of money in the market, the temptation to influence and manipulate the market is limited to the present.

In fact, Hamilton believed that it’s almost impossible to manipulate or influence the main trend of the market. However, he did not question the price manipulation by brokers, experts or anyone else in the market. In other words, the daily or secondary price movements may tend to accept the impact of influences. These changes may last for hours or weeks, and they could implement by large institutions, brokers, news or rumors around the market. For instance, between the years 1970 and 1980, the Hunt brothers manipulated the price of silver. The price of silver reached $50 per ounce for a while due to their action, but very soon the prices fell again and the market resumed the bearish trend.

 

Averages reduce everything

The second assumption is that the price reflects all the information. In fact, the price reflects all the fears, hopes and expectations of the shareholders. Interest rates, expectations, revenue plans, presidential elections, product innovation, new products and everything else will affect the price. In addition, Hamilton believes that sometimes the market shows a negative response to good news. The reasons for that was simple for Hamilton. The market is always moving forward. Whenever news is published, it will affect the prices. In other words, it describes the famous Wall Street rule, which says buy rumors, sell news.
The fact is that when a rumor disappeared, buyers will show up in the market and increase the prices. On the other hand, when news is published, prices show reaction to the news and start to grow.

Dow’s theory is not infallible

In fact, both Hamilton and Dow accepted that this theory is not an absolute guide. However, it’s a set of rules and principles, which help traders and investors in their own interpretation of the market. This theory creates a mechanism, which we can eliminate some emotions. Hamilton always mentioned that investors should not be influenced by their wishes and personal desires. It means, that they should be realistic when it comes to investing. In fact, they should see the reality of the market and not what they like to see. The reason is that investors, who stayed for long in the market prefer to see the price growth signs and not the falling signs. On the other hand, who were out of the market or participated in the market for a short period, prefer to see the negative aspects of the market.

In addition, this theory is not suitable for short-term trades. However, it could be suitable for large transactions. In fact, the Dow theory is appropriate in order to recognize the main trend. As a result, it could be a suitable tool to use for all kinds of trades regardless of what time frame chosen for the trade.

 

Dow Theory; Rules of extensive market movements

Robert Rhae turned the Hamilton and Dow theories into a number of separate rules. In this part, we state the rules, which are focused on the behavior and type of the market trends.

 

Market movements

Dow and Hamilton defined three types of price movements in Dow Jones Industrial and Dow Jones Rail stocks. They consist of main movements, secondary movements and daily fluctuations. The main movement of the market, which can last from months to years, indicates the main broad trend of the market. The secondary movements, which can last from weeks to months, move in the opposite direction of the main trend. Finally, the daily fluctuations, which may take from hours to days, could move in the same or opposite direction of the main trend. However, they rarely last for more than a week.

 

The main trend of the market

As we mentioned above, the main trend reflects the general and broad trend of the market, which could last from months to years. These movements usually introduce as a Bullish or Bearish market.

Bullish market refers to a market, which the prices are surging continuously. Conversely, the Bearish market refers to a market, which prices are falling continuously or experiencing recession.

Once the main trend of the market is identified, the trend will remain until proven otherwise. Most investors and traders are confused about price and time targets. In fact, nobody knows when and where the main trend will stop. Hamilton believed that the time and duration of the trend is almost unpredictable. The aim of  Dow theory is to use whatever we know and not to guess what we do not know about.  In fact, this theory provides a set of guidelines, which enables the investors to recognize and understand the main market trend and invest accordingly.

 

Secondary movements

Secondary movements move against the main trend and are inherently resilient. A secondary movement in a Bull market consider as a ‘price correction’, while in a Bear market it is called ‘jump’.  The figure below shows a jump (blue color rectangles) in Coca Cola falling market between the years 1998 and 1999.

Coca-Cola Chart
Coca-Cola Price Chart

 

Hamilton acquired a number of common features of secondary movements. Although they should not be considered as rules, they can play a role as guidelines alongside analytical techniques.

  • Hamilton estimated that the secondary movement returns between one-third to two-thirds of the main movement, which is typically 50%.
  • In addition, Hamilton realized that the secondary movement tends to move quicker and faster than a main trend.
  • After the end of the secondary movement and before the beginning of the main trend, we confront a boring period. This period could be recognizable either by the small movements of the price or a reduction in trading volume or even a combination of both of them.

The figure below, shows the Ethereum price chart between the January to April 2018. In fact, it shows the feature, which Hamilton mentioned.

Ethereum Chart
Ethereum Price Chart

Hamilton described the secondary movements as an essential phenomenon to combat destructive and excessive speculations. In fact, the movements against the secondary movement help traders to identify the main trade with more assurance. However, traders should be more careful in their analysis and studies due to the complex and deceptive of the nature of these secondary movements. In fact, usually, traders and investors make a mistake and consider the secondary movement as a beginning of a new main trend. The question, which pops up here is that until where the secondary movement usually must go to affect the main trend?

In this article we are going to explain the various signals, which are introduced by Dow theory as well as answering to the question above.

 

Daily fluctuations

Daily fluctuations are important, when they come as a group, along with the fluctuations of the previous days. Conversely, they would be dangerous and unreliable, whenever they appear separated from the previous days. In fact, the prediction of the value of daily fluctuations at best are limited because the movements are random and not following any rules. In the worst case, focusing on these moves can lead to wrong predictions or even loss of capital. When a trader involves excessively with these movements, it may cause making hasty decisions, which are based on emotions. It’s important to have an overview of the market when trading on the daily basis. In fact, the trader should see the fluctuations as pieces of a puzzle. Therefore, some pieces of this puzzle are basically meaningless. However, they are important in order to complete the overview of the market.

Not only Hamilton did not neglect the daily fluctuations, but also he insisted on. In fact, he believed that studying the market movements on a daily basis will help to develop an inner insight. However, they have to consider in a larger image from the market. In fact, there are not much information in the market movements in a day, two days or even three days. Meanwhile, when several these daily fluctuations come next to each other, it will form an overall structure and provide better analysis as well.

 

Dow Theory; Three Phases of the market in the main uptrend

Hamilton defined three Phases for both Bull market and Bear market. These three phases consider the price movements as well as psychological issues. A Bull main uptrend will define as a sustainable uptrend. In fact, this uptrend will form due to improved business conditions, which eliminate excess speculation and increase the demand for investment in the market. Actually, we have secondary movements in this uptrend, which move in the opposite direction. The three phases of a Bull market are as below:

 

Phase 1- accumulation

Hamilton explains that it would be difficult to distinguish the first phase of the bull market from the last jump of the Bear market. In fact, the pessimism from the Bear market exists at the beginning of the Bull market as well. The fact is that the majority of traders and investors exited the market at the beginning of the Bull market. This point is, where the so-called “smart money” begins to accumulate stocks. The price of the stock is low at this point and it seems that no one is interested in it. It was in the summer 1974 that Warren Buffet announced that it is the suitable time to buy stocks and make money. However, no one took him serious. Therefore, he was the only person, who recognized correctly the accumulation phase of the uptrend market at that time.

In fact, at the first phase of Bull market, stock prices begin to find the lowest and most stable price. As the market begins to grow, a speculation will develop by the majority that the Bull market is going to begin. Once the first price peak formed and a downtrend resumed, the Bears claim that the downtrend will continue and did not over yet.

In this situation, the conscious analysts can make sure that the price decline is the secondary movement not the main trend. When a higher low appears and a boring trend comes along to stable the price, it shows that an uptrend began (a higher low appears when the price declines to a point and begin to start rising again). When a higher high appears, it confirms the beginning of the second high as well as the beginning of an uptrend (the higher high appears when the price surges to a point and then continue rising).

 

Phase 2- Great move (public participation)

Usually the second phase of the main ascending trend is the longest phase. In fact, the highest price growth takes place at this time. This phase recognizes through the improvement in businesses as well as the increase in stock value. Meanwhile, the revenue from purchases of stock starts rising again and the self-confidence goes up. This phase is the easiest part of the uptrend in order to make a profit. The reason is that contribution increases at this phase.

 

Phase 3- Excess

The third phase is recognizable through excessive speculations and the emergence of inflationary pressures. During the third phase, which is the last one, the public fully involved the market, the value of the market and stock surge and the self-confidence meet the highest point. In fact, this phase is the mirror image of the first uptrend phase.

A Wall Street principle: when taxi drivers start to ask for tips, the highest price is not far off.

Dow Theory; Three phases of the market in the main downtrend

The main downtrend defines as a long-term sustainable reduction. This phase recognizes through worsening situation, which results in declining demand for stock. Similar to the Bull market, in the main Bear market, we also witness a secondary movement, which is in the opposite direction of the main trend.

 

Phase 1- Distribution

As the accumulation is the first phase of the beginning of the Bull market, the distribution considers as the beginning of the Bear market. Once the “Smart Money” realize that the market conditions are not as good as they thought, they start to sell their stock. At this phase, the public are still involved in the market and show attraction to buy. At this time, we may hear or read in the news that the market conditions are still going well. However, the stocks begin a downtrend.

At the beginning of the Bear market, not many believe that the downtrend started, and they still predict that market will stay Bullish. After a moderate period of decline, a secondary movement will appear, which reimburse a part of the price decline. Hamilton shows that the price jumps in descending market, which are secondary movements, happen quickly and fast.

As Hamilton analyzed, a large percentage of losses will reimburse over the period of days or weeks. This quick move makes the bulls to claim that the market is still under their control. However, the corrected price is lower than the previous one.

 

Phase 2- Great move

The second phase of the main downtrend consists of a large move the same as the second wave of the Bull market. At this condition, the main trend will consider as the Bear market and it worse the business condition. The Revenue of buying stock will decline, deficiencies occur, profit margins reduce and the revenues fall. As business condition becomes worse, the stock sales continue.

 

Phase 3- Frustration

At the final phase of the Bear market, the market becomes frustrated and valuations decline. However, the sell is still continuing. The economic outlook is bleak and no buyer can be found. The market keeps falling until the negative news spread through the market. Once the stock reacted to the worst possible event, the next cycle will resume.

 

Dow Theory; Signal rules

Rhae extracted 4 rules and principles from the writings of Dow and Hamilton. These rules and principles are related to:

  • Trend identification
  • Buy and sell signals
  • Trading volume
  • Trading range

The first two principles are the most important, which are used to identify the Bear or Bull markets. Hamilton believed that the third and fourth principles are not beneficial to identify the trend. However, they could help to identify the existing market trend and information about investing in the market.

 

Trend identification

Hamilton identified the trend by analyzing the tops and bottoms. A growing trend is recognizable by upward tops and bottoms. The opposite of the condition is also true. In fact, when a trend identified, it would be valid until the position of the tops and bottoms relative to each other do not violate the uptrend or downtrend. It means that in an uptrend every top or bottom should be above its previous top or bottom. On the other hand, in a downtrend every top or bottom should be below its previous top or bottom.

In order to identify a trend, it is necessary to become familiar with the below terms:

Trend Identification
Trend Identification Chart

HH: (Higher High) A top, which is above its previous top.

HL: (Higher Low) A bottom, which is above its previous bottom.

LH: (Lower High) A top, which is lower than its previous top.

LL: (Lower Low) A bottom, which is lower than its previous bottom.

In order to understand these terms easier, we put the Ethereum price chart as an example. Although Hamilton and Dow did not note anything about the market trend line, we drew a line to show the downtrend. As the figure shows, after the top formed in early May 2018, we have several LH and LL in the downtrend. There are several secondary movements as well, which marked with red circles.

LL & LH In Ethereum Chart
LL & LH In Ethereum Price Chart

On the other hand, in the main uptrend or Bullish trend we have several HH and HL. The figure below is the Litecoin price chart in early February 2019 until the late Jun, which shows an uptrend. The orange color arrows show LL followed by LH, which indicates the end of the main uptrend.

Litecoin Chart
Litecoin Price Chart

It is notable that Dow theory is not science and Hamilton mentioned this fact several times. In fact, this theory could be just a guidance to study the market movements and price fluctuations carefully.

Hamilton and Dow were interested in noticing the great moves and used the weekly charts much. However, in today’s volatile world, the weekly charts may not provide enough details, which traders require. Therefore, using a short moving average could be a suitable solution. For instance, a 5 day moving average could be helpful to smooth prices and recognize the details. A moving average means, the average information of price in a certain period (for example 5 days).

 

Dow Theory; Buy and sell signals

When the Dow theory was shaping in early of 20th century, the transportation and railway industry had a vital relation with economy. Hamilton stated that in most cases, the activity of charts is specified in the railway stock chart. The reason was that the raw materials was transporting to factories by using the railway. As a result, the surging in railway activities or generally transportation could indicate the beginning of the manufacturing.

Dow and Hamilton always mentioned that both the transportation and manufacturing industries must validate each other in order to validate the main trend. If the stock of manufacturers surge along with transportation companies, it could be a buy signal. On the other hand, the decline of the stocks in these two industries, could be a sell signal. In the modern economic world also changes in economic activities, revenue rate, energy and labor costs could affect the main economic activities. These days, airlines replaced the railway and play a significant role in the economy.

 

Dow Theory; Trading volume

Hamilton believed that trading volume must validate the main trend of the market. In fact, in a Bull trend, trading volume must be higher at the beginning of the trend rather than the correction period. Not only the corrections come along with decline in trading volume, but also the contribution experience reduction as well. According to Hamilton, at the time of a correction, the market should be “narrow and cloudy”.

Narrow means that the news about the market decline should not spread significantly. This trend is also true in the downtrend market. It means that in Bear market also should be a decline in trading volume in the main downtrend as well as a decline at the time of the jump. In addition, the market must be narrow and has less contribution, when the prices jump. It could be possible to judge the power of the main trend by analyzing the Bull markets correction and Bear markets jumps. Hamilton shows that high trading volume could indicate an impending reversal. It means, when a day passes with high trading volume after a long growth in the market, it could indicate that trend will change and react soon.

 

Dow Theory; Trading range

Hamilton mentioned about (Lines) for several times in his commentaries. In this case, (lines) refers to the horizontal lines, which show the trading range. These lines are created when the chart moves in a certain period and make us be able to draw the horizontal lines in order to connect the tops and bottoms together.

In fact, these trading ranges indicate the accumulation or distribution phase. However, it is impossible to recognize the differences between these two phases unless the chart breaks this horizontal line to one side. In this case, if the chart breaks the line upward, it shows the accumulation phase. On the other hand, if the chart breaks the line downward, it shows the distribution phase. In the figure below, the trading range is indicated with a red color circle in Bitcoin price chart.

Bitcoin Chart
Trading Range In Bitcoin Chart

 

Criticisms of Dow’s theory

The first critique of this theory is that it is not specifically a theory because Dow and Hamilton did not publish an academic article in order to test the rules and principles. In fact, these articles published in Wall Street Journal and Rhea merged them together.

The second is that Dow theory look into long period. In fact, many traders believe that by using this theory, they will miss most of the chart movements.

The third is that this theory is expired and could not be a precious reflect of the market because Dow and Hamilton used DJIA charts (Dow’s industrial average index is an economic market index, which has been published by Wall Street Journal since 1896) and DJTA (Dow’s transportation average index is a stock market index in the transportation sector). However, DJTA is one of the critic economic indexes. The market stock always considers as a sign of the market growth or recession.

 

Dow Theory; Conclusion

The aim of this theory is to identify the main market trend and use the great movements efficiently. Dow and Hamilton realized that the market is affected by emotions and tends to react to it. With this in mind, they focused on identifying and following up the market trends. A trend will continue unless proven otherwise. In fact, this theory could help traders to identify the truth and not the assumptions and predictions. Taking an assumption is risky and dangerous. Although prediction is not impossible, it would not be easy. Since the Dow theory can create the basis of analysis, it would be a beginning point for traders and investors to analyze the market using their own tools and strategies.

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