“The Dow theory has been around for almost 100 years, yet even in today’s volatile and technology-driven markets, the basic components of Dow theory still remain valid. Developed by Charles Dow, refined by William Hamilton and articulated by Robert Rhea, the Dow theory addresses not only technical analysis and price action, but also market philosophy.
Even though Charles Dow is credited with developing the Dow theory, it was S.A. Nelson and William Hamilton who later refined the theory into what it is today. Nelson wrote The ABC of Stock Speculation and was the first to actually use the term “Dow theory.” Hamilton further refined the theory through a series of articles in The Wall Street Journal from 1902 to 1929. Hamilton also wrote The Stock Market Barometer in 1922, which sought to explain the theory in detail.
In 1932, Robert Rhea further refined the analysis of Dow and Hamilton in The Dow Theory. Rhea read, studied and deciphered some 252 editorials through which Dow (1900-1902) and Hamilton (1902-1929) conveyed their thoughts on the market. Rhea also referred to Hamilton’s The Stock Market Barometer. The Dow Theory presents the Dow theory as a set of assumptions and theorems.
Even though the theory is not meant for short-term trading, it can still add value for traders. No matter what your time frame, it always helps to be able to identify the primary trend. According to Hamilton (writing in the early part of the 20th century), those who successfully applied the Dow theory rarely traded more than four or five times a year. Remember that intraday, day-to-day and possibly even secondary movements can be prone to manipulation, but the primary trend is immune from manipulation. Hamilton and Dow sought a means to filter out the noise associated with daily fluctuations. They were not worried about a couple of points, or getting the exact top or bottom. Their main concern was catching the large moves. Both Hamilton and Dow recommended close study of the markets on a daily basis, but they also sought to minimize the effects of random movements and concentrate on the primary trend. It is easy to get caught up in the madness of the moment and forget the primary trend. After the October low, the primary trend for Coca-Cola remained bearish. Even though there were some sharp advances, the stock never forged a higher high.” ( explanation courtesy of Stockcharts.com).
The main assumptions of the Dow Theory are that:
1. The PRIMARY TREND cannot be manipulated
2. The MARKET AVERAGES reflect all known information
Secondary movements, these short movements from a few hours to a few weeks, could be subject to manipulation by large institutions, speculators, breaking news or rumors, but the primary trend, could not be manipulated.
FOR EXAMPLE: The current PRIMARY TREND is a SECULAR BEAR MARKET, whereas the secondary trend is a
BEAR market rally. Understanding this distinction is vital to protecting your capital …..otherwise, you will continue to be bullish, in the face of a significant correction.
THUS, this current rally is shorter term in nature, and is likely coming to the end of its run. Similarly to the high tech correction of 2001, and the credit bubble correction of 2008, another correction is on the horizon. CAUTION is the key word here.
Dow Theory, outlines 5 different phases of a market cycle . One analyst that has been very accurate with Dow Theory is Tim Wood. He stipulates that we are about to enter “PHASE II”, which will be even more devastating that Phase I. I have added the URL below to his current article, updating his analysis:
http://www.financialsense.com/Market/wood/2009/1218.html
2010 has the potential to produce some exceptional investing opportunities for those that are prepared. Otherwise, it could be a very difficult and painful one, for those investors that get caught in the wrong trend.
Best wishes of the season !!
Mike McGann
