The relevance of Dow Theory:: Business Line

Please Share:: India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��

Charles Dow, the ‘grand-daddy' of technical analysis is best remembered as the creator of the Dow Jones indices, many of which are widely followed even today.

However the same can not be said of the Dow Theory that he propagated in a series editorials on stock market behaviour between 1851 and 1902 in the Wall Street Journal.

Though this is one of the first theories that attempted to explain stock market movement, there are many who question its relevance in modern times.

TRENDS

According to this theory, market moves in trends. Dow identified three types of trends. The primary trend defines the bull or the bear market and lasts from a few months to many years.

Moves in the direction opposite to the primary movement are called the secondary trend or the medium swing.

These moves last between ten days to three months and retrace from 33 to 66 per cent of the primary move.

The smaller trends that keep altering every day or even every hour is the third kind of market movement or the short swing.

These classifications were used by other technical analysts such as R.N. Elliott to build their theory. Elliott polished the three moves of Dow to such an extent that he made it possible to label every little wiggle on the intra-day chart.

Such refinements have made Dow's trend classifications almost redundant.

But his explanation of the phases within the market trend can still be used by analysts to gauge how long the trend can last.

PHASES

The Dow Theory states that the first phase in a primary uptrend is accumulation. In this phase, the speculative froth is entirely out of the market.

Investors are dejected after having sold their holdings at a big loss.

The larger players start accumulating stocks at this juncture. There is no perceptible price movement though things start stabilising.

The second phase is the big move in which prices start zooming upwards and there is a rush to climb on to the bandwagon, pushing prices higher and higher.

The third phase is the distribution, where the early entrants book profits and exit. The less informed investors enter in this stage. There is euphoria and overwhelming optimism all around.

The reverse would happen when the primary trend is down.

It would start with a feeling of euphoria, which would also be the distribution phase, followed by a big move down and then there would be the great despair which would actually be the beginning of the next bull market.

Keeping in mind these psychological signals will go a long way in helping an investor judge how far the existing trend can last.

For instance, all the signals that Dow used to describe the final phase were present in the last quarter of 2007.

Similarly the doom and despair in the first quarter of 2009 was screaming the end of the bear market.

Another utility of the Dow Theory is helping the novice trader judge when to exit a position. The theory states that an uptrend lasts as long as the sequence of higher peaks and troughs remains unbroken.

The up-trend reverses when the market fails to record a higher peak and the trough that follows falls below the previous trough.

The reverse is true in a downtrend.

The index would be construed to be in a downtrend as long as it records lower peaks and troughs.

The downtrend will reverse when the index records a higher trough and then moves above the preceding peak.

There are, however, some analysts who argue that the stock or the index could have made a major move against the trend before the reversal is confirmed.

Using this method in combination with other tools of technical analysis can help to overcome this difficulty