Wednesday, 7 March 2012

ANALYSIS STOCK TRENDS, Chapter 3 , The Dow Theory


Robert D. Edwards
John Magee

Chapter 3

The Dow Theory

 The Dow Theory is the granddaddy of all technical market
studies. Although it is frequently criticized for being "too
late," and occasionally derided (particularly in the early stages of a Bear Market) by those who rebel at accepting its verdicts, it is known by name to nearly everyone who has had any association with the stock market, and respected by most. Many who heed it in greater or lesser degree in determining their investment policies never realize that it is purely and simply "technical." It is built upon and concerned with nothing but the action of the stock market itself (as expressed in certain "averages"), deriving nothing from the business statistics on which the fundamentalists depend.


There is much in the writings of its original promulgator,
Charles H. Dow, to suggest that he did not think of his "theory" as a device for forecasting the stock market, or even as a guide for investors, but rather as a barometer of general business trends. Dow founded the Dow-Jones financial news service and is credited with the invention of stock market averages. The basic principles of the Theory, which was later named after him, were outlined by him in editorials he wrote for The Wall Street Journal. Upon his death in 1902, his successor as editor of the journal, William P. Hamilton, took up Dow's principles and, in the course of 27 years of writing on the stock market, organized them and formulated them into the Dow Theory as we know it today.

Before we proceed to an explanation of the Theory itself, it will
be necessary to examine the stock averages which it employs. Long before the time of Dow, the fact was familiar to bankers and businessmen that the securities of most established companies tended to go up or down in price together.

which moved against the general financial tide—were rare, nor
did they as a rule persevere in that contrary course for more than a few days or weeks at a time. It is true that when a boom was on, he prices of some issues rose faster and farther than others, and when the trend was toward depression, some stocks declined rapidly while others would put up considerable resistance to the forces that were dragging the market down—but the fact remained that most securities tended to swing together. (They still do, needless to say, and always will.)
This fact, as we have said, has long been commonly known
and accepted—so completely taken for granted that its importance is usually overlooked. For it is important—tremendously important from many angles in addition to those which come within the province of this volume. One of the best of all reasons for a student of market technics to start with the Dow Theory is because that theory stresses the general market trend.

Charles Dow is believed to have been the first to make a
thoroughgoing effort to express the general trend (or, more correctly, level) of the securities market in terms of the average price of a selected few representative stocks. As finally set up in January of 1897, in the form which has continued to date, and used by Dow in his studies of market trends, there were two Dow-Jones averages.

One was composed of the stocks of twenty railroad companies
only, for the railroads were the dominant corporate enterprises of his day. The other, called the Industrial average, represented all other types of business, and was made up, at first, of only twelve issues.

This number was increased to twenty in 1916 and to thirty
on October 1,1928. 

The Dow Averages

The stocks included in these two averages have been changed
from time to time in order to keep the lists up-to-date and as nearly representative as possible of their respective groups. It is interesting to note that the only railroad stock which has been included in the Rail average continuously from 1897 to 1956 is New York Central.

Only General Electric, of the present thirty industrial stocks, was included in the original Industrial average, and that
was dropped at one time (in 1898) and subsequently reinserted. In 1929, all stocks of public utility companies were dropped from the Industrial average and a new Utility average of twenty issues was set up; in 1938 its number was reduced to fifteen. The twenty rail, thirty industrial and fifteen utility stocks are now averaged together to make what is known as the Dow-Jones 65-Stock Composite. The history of these averages, the various adjustments that have been made in them and their method of computation, is an interesting story in itself which the reader may want to look up elsewhere. For our present purpose, it remains only to add that the Dow Theory pays no attention to the Utility or Composite
averages; its interpretations are based on the Rail and Industrial
averages only. (Although the specific Dow-Jones averages are always
used in this connection, the Theory would presumably work
just as well with any other equally representative indexes of railroad and industrial stocks.)
In recent years, the values of the Dow-Jones averages have
been computed for the end of each hour of trading as well as the
end of the day. These hourly figures are published in The Wall
Street Journal as well as on the Dow-Jones news ticker service. 

The Wall Street Journal also prints in each issue a summary of the important highs and lows of each average by date for the preceding two or three years. Their daily closing prices are reported in many other metropolitan daily newspapers.
Basic Tenets To get back to the Dow Theory, itself, here are its basic tenets:


1. The Averages Discount Everything (except "Acts of
God")—Because they reflect the combined market activities
of thousands of investors, including those possessed of the greatest foresight and the best information on trends and events, the averages in their day-to-day fluctuations discount everything known, everything foreseeable, and every condition which can affect the supply of or the  demand for corporate securities. Even unpredictable
natural calamities, when they happen, are quickly appraised
and their possible effects discounted.

2. The Three Trends—The "market," meaning the price of
stocks in general, swings in trends, of which the most important
are its Major or Primary Trends. These are the extensive
up or down movements which usually last for a year or more and result in general appreciation or depreciation in value of more than 20%. Movements in the direction of the Primary trend are interrupted at intervals by Secondary swings in the opposite direction—reactions or "corrections" which occur when the Primary move has temporarily "gotten ahead of itself." (Both Secondaries and the intervening segments of the Primary trend are frequently lumped together as Intermediate movements—a term which we shall find useful in subsequent discussions.) Finally, the Secondary trends are composed of Minor trends or day-to-day fluctuations which are unimportant.

3. The Primary Trends—These, as aforesaid, are the broad,
overall up and down movements which usually (but not
invariably) last for more than a year and may run for
several years. So long as each successive rally (price advance)
reaches a higher level than the one before it, and
each secondary reaction stops (i.e., the price trend reverses
from down to up) at a higher level than the previous reaction,
the Primary Trend is Up. This is called a Bull Market.
Conversely, when each intermediate decline carries prices
to successively lower levels and each intervening rally fails
to bring them back up to the top level of the preceding
rally, the Primary Trend is Down, and that is called a Bear
Market. (The terms bull and bear are frequently used loosely
with reference, respectively, to any sort of up or down
movements, but we shall use them in this book only in connection with the Major or Primary movements of the
market in the Dow sense.)  Ordinarily—theoretically, at least—the Primary is the only one of the three trends with which the true long-term investor is concerned. His aim is to buy stocks as early as possible in a Bull Market—just as soon as he can be sure that one has started—and then hold them until (and only until) it becomes evident that it has ended and a Bear
Market has started. He knows that he can safely disregard
all the intervening Secondary reactions and Minor fluctuations.
The trader, however, may well concern himself also with the Secondary swings, and it will appear later on in this book that he can do so with profit.

The Secondary Trends—These are the important reactions
that interrupt the progress of prices in the Primary direction.
They are the Intermediate declines or "corrections" which occur during Bull Markets, the Intermediate rallies or "recoveries" which occur in Bear Markets. Normally,
they last for from three weeks to as many months, and
rarely longer. Normally, they retrace from one-third to
two-thirds of the gain (or loss, as the case may be) in prices
registered in the preceding swing in the Primary direction.
Thus, in a Bull Market, prices in terms of the Industrial
average might rise steadily, or with only brief and minor
interruptions, for a total gain of 30 points before a Secondary
correction occurred. That correction might then be expected
to produce a decline of not less than 10 points and
not more than 20 points before a new Intermediate advance
in the Primary Bull trend developed.


Note, however, that the one-third/two-thirds rule is not an
unbreakable law; it is simply a statement of probabilities.
Most Secondaries are confined within these limits; many of
them stop very close to the halfway mark, retracing 50% of
the preceding Primary swing; they seldom run less than
one-third, but some of them cancel nearly all of it.
Thus we have two criteria by which to recognize a Secondary

Any price movement contrary in direction to  the Primary trend which lasts for at least three weeks and retraces at least one-third of the preceding net move in the Primary direction (from the end of the preceding Secondary to the beginning of this one, disregarding minor fluctuations) is labeled as of Intermediate rank, i.e., a true Secondary. 

Despite these criteria, however, the Secondary trend is often confusing; its recognition, its correct appraisal at the time it develops and while it is in process, poses the Dow Theorist's most difficult problem. We shall have more to say about this later.


5. The Minor Trends—These are the brief (rarely as long as
three weeks—usually less than six days) fluctuations which
are—so far as the Dow Theory is concerned—meaningless
in themselves, but which, in toto, make up the Intermediate
trends. Usually, but not always, an Intermediate swing,
whether a Secondary or the segment of a Primary between
successive Secondaries, is made up of a series of three or
more distinguishable Minor waves. Inferences drawn from
these day-to-day fluctuations are quite apt to be misleading.
The Minor trend is the only one of the three trends
which can be "manipulated" (although it is, in fact, doubtful
if under present conditions even that can be purposely
manipulated to any important extent). Primary and Secondary
trends cannot be manipulated; it would strain the
resources of the U.S. Treasury to do so. Right here, before we go on to state a sixth Dow tenet, we may well take time out for a few minutes to clarify the concept of the three trends by drawing an analogy between the movements of the stock market and the movements of the sea. The Major (Primary) trends in stock prices are like the tides. We can compare a Bull
Market to an incoming or flood tide which carries the water farther and farther up the beach until finally it reaches high-water mark and begins to turn. Then follows the receding or ebb tide, comparable to a Bear Market. But all the time, during both ebb and flow of the tide, the waves are rolling in, breaking on the beach and then receding. While the tide is rising, each succeeding wave pushes a little farther up onto the shore and, as it recedes, does not carry the water quite so far back as did its predecessor. During the tidal ebb, each advancing wave falls a little short of the mark set by the one before it, and each receding wave uncovers a little more of the beach. These waves are the Intermediate trends—Primary or Secondary depending on whether their movement is with or against the direction of the tide. Meanwhile, the surface of the water is constantly agitated by wavelets, ripples and "catspaws"
moving with or against or across the trend of the waves—these are analogous to the market's Minor trends, its unimportant day-today fluctuations.

The tide, the wave and the ripple represent,
respectively, the Primary or Major, the Secondary or Intermediate, and the Minor trends of the market.


Tide, Wave and Ripple 

A shore dweller who had no tide table might set about determining the direction of the tide by driving a stake in the beach at the highest point reached by an incoming wave.

Then if the next
wave pushed the water up beyond his stake he would know the
tide was rising. If he shifted his stake with the peak mark of each
wave, a time would come when one wave would stop and start to
recede short of his previous mark; then he would know that the
tide had turned, had started to ebb. That, in effect (and much
simplified), is what the Dow Theorist does in defining the trend of the stock market.

The comparison with tide, wave and ripple has been used
since the earliest days of the Dow Theory. It is even possible that
the movements of the sea may have suggested the elements of the
theory to Dow. But the analogy cannot be pushed too far. The tides and waves of the stock market are nothing like as regular as those of the ocean. 

Tables can be prepared years in advance to predict
accurately the time of every ebb and flow of the waters, but no
timetables are provided by the Dow Theory for the stock market.
We may return to some points of this comparison later, but we A shore dweller who had no tide table might set about determining
the direction of the tide by driving a stake in the beach at
the highest point reached by an incoming wave. Then if the next
wave pushed the water up beyond his stake he would know the
tide was rising. If he shifted his stake with the peak mark of each
wave, a time would come when one wave would stop and start to
recede short of his previous mark; then he would know that the
tide had turned, had started to ebb. That, in effect (and much
simplified), is what the Dow Theorist does in defining the trend of the stock market.

The comparison with tide, wave and ripple has been used
since the earliest days of the Dow Theory. It is even possible that
the movements of the sea may have suggested the elements of the
theory to Dow. But the analogy cannot be pushed too far. The tides and waves of the stock market are nothing like as regular as those of the ocean.

Tables can be prepared years in advance to predict
accurately the time of every ebb and flow of the waters, but no
timetables are provided by the Dow Theory for the stock market.

We may return to some points of this comparison later, but we must proceed now to take up the remaining tenets and rules of the Theory.

Major Trend Phases


6. The Bull Market—Primary uptrends are usually (but not
invariably) divisible into three phases. The first is the phase
of accumulation during which farsighted investors, sensing
that business, although now depressed, is due to turn up, are willing to pick up all the shares offered by discouraged and distressed sellers, and to raise their bids gradually as such selling diminishes in volume. Financial reports are still bad—in fact, often at their worst—during this phase. 

The "public" is completely disgusted with the stock
market—out of it entirely. Activity is only moderate but
beginning to increase on the rallies (minor advances).

The second phase is one of fairly steady advance and increasing
activity as the improved tone of business and a rising trend
in corporate earnings begin to attract attention. It is during
this phase that the "technical" trader normally is able to
reap his best harvest of profits. Finally comes the third
phase when the market boils with activity as the "public"
flocks to the boardrooms.

All the financial news is good;
price advances are spectacular and frequently "make the
front page" of the daily papers; new issues are brought out
in increasing numbers. It is during this phase that one of
your friends will call up and blithely remark, "Say, I see the
market is going up. What's a good buy?"—all oblivious of
the fact that it has been going up for perhaps two years, has
already gone up a long ways and is now reaching the stage
where it might be more appropriate to ask, "What's a good
thing to sell?" In the last stage of this phase, with speculation
rampant, volume continues to rise, but "air pockets"
appear with increasing frequency; the "cats and dogs"
(low-priced stocks of no investment value) are whirled up,
but more and more of the top-grade issues refuse to follow

7. The Bear Market—Primary downtrends are also usually
(but again, not invariably) characterized by three phases.
The first is the distribution period (which really starts in the
later stages of the preceding Bull Market).

During this
phase, farsighted investors sense the fact that business
earnings have reached an abnormal height and unload
their holdings at an increasing pace.

Trading volume is still
high though tending to diminish on rallies, and the
"public" is still active but beginning to show signs of
frustration as hoped-for profits fade away. The second
phase is the panic phase.

Buyers begin to thin out and
sellers become more urgent; the downward trend of prices
suddenly accelerates into an almost vertical drop, while
volume mounts to climactic proportions.

After the panic
phase (which usually runs too far relative to then-existing
business conditions), there may be a fairly long Secondary
recovery or a sidewise movement, and then the third phase
begins. This is characterized by discouraged selling on the
part of those investors who held on through the panic or,
perhaps, bought during it because stocks looked cheap in
comparison with prices which had ruled a few months earlier.
The business news now begins to deteriorate.

As the third phase proceeds, the downward movement is less
rapid, but is maintained by more and more distress selling
from those who have to raise cash for other needs. The
"cats and dogs" may lose practically all their previous Bull
advance in the first two phases. 

Better grade stocks decline
more gradually, because their owners cling to them to the
last, and the final stage of a Bear Market, in consequence, is
frequently concentrated in such issues. The Bear Market
ends when everything in the way of possible bad news, the
worst to be expected, has been discounted, and it is usually
over before all the bad news is "out." The three Bear Market phases described in the preceding paragraph are not the same as those named by others who have discussed this subject, but the writers of this study feel that they represent a more accurate and realistic 

division of the Primary down moves of the past thirty
years. The reader should be warned, however, that no two
Bear Markets are exactly alike, and neither are any two Bull
Markets. Some may lack one or another of the three typical

A few Major advances have passed from the first to
the third stage with only a very brief and rapid intervening
markup. A few short Bear Markets have developed no
marked panic phase and others have ended with it, as in
April 1939. No time limits can be set for any phase; the third stage of a Bull Market, for example, the phase of excited
speculation and great public activity, may last for more than a year or run out in a month or two. The panic phase of a Bear Market is usually exhausted in a very few weeks if not in days, but the 1929 through 1932 decline was interspersed with at least five panic waves of major proportions.

Nevertheless, the typical characteristics of
Primary trends are well worth keeping in mind. 

If you know the symptoms which normally accompany the last
stage of a Bull Market, for example, you are less likely to be
deluded by its exciting atmosphere.

Principle of Confirmation
8. The Two Averages Must Confirm—This is the most often
questioned and the most difficult to rationalize of all the
Dow principles. 

Yet it has stood the test of time; the fact
that it has "worked" is not disputed by any who have carefully
examined the records. Those who have disregarded it
in practice have, more often than not, had occasion to
regret their apostasy.

What it means is that no valid signal
of a change in trend can be produced by the action of one
average alone. Take, for example, the hypothetical case
shown in Diagram 1 on the previous page. In this, we assume
that a Bear Market has been in effect for several
months and then, starting at a, the Industrial average rises
(along with the Rails) in a Secondary recovery to b. On
their next decline, however, the Industrials drop only c,
which is higher than a, and then turn up to d, which is
higher than b.

At this point, the Industrials have "signaled"
a change in trend from down to up. But note the Rails
during this period; their decline from b to c carried them
lower than a, and their subsequent advance from c to d has
not taken them above b. 

They have (so far) refused to confirm
the Industrials and, hence, the Major trend of the
market must be regarded as still Down. Should the Rails go
on to rise eventually above their b, then, and then only, would we have a definite signal of a turn in the tide. Until
such a development, however, the chances remain that the
Industrials will not be able to continue their upward course
alone, that they will ultimately be dragged down again by
the Rails. At best, the direction of the Primary trend is still
in doubt.

The above illustrates only one of the many ways in which
the principle of confirmation applies. Note also that at c, it
might have been said that the Industrials had thus far not
confirmed the Rails in continuing the downtrend—but this
had to do only with the continuation or reaffirmation of an
existing trend, regarding which more later. It is not necessary
that the two averages confirm on the same day. 

Frequently both will move into new high (or low) ground
together, but there are plenty of cases in which one or the
other lags behind for days, weeks or even a month or two.
One must be patient in these doubtful cases and wait until
the market declares itself in definite fashion.

"Volume Goes with the Trend"—Those words, which you
may often hear spoken with ritual solemnity but little understanding, are the colloquial expression for the general
truth that trading activity tends to expand as prices move
in the direction of the prevailing Primary trend. Thus, in a
Bull Market, volume increases when prices rise and
dwindles as prices decline; in Bear Markets, turnover increased
when prices drop and dries up as they recover.

To a lesser degree, this holds for Secondary trends also, especially in the early stages of an extended Secondary recovery
within a Bear Market, when activity may show a tendency
to pick up on the Minor rallies and diminish on the Minor
setbacks. But to this rule, again, there are exceptions, and
useful conclusions can seldom be drawn from the volume
manifestations of a few days, much less a single trading
session; it is only the overall and relative volume trend
over a period of time that may produce helpful indications.
Moreover, in Dow Theory, conclusive signals as to the 
market's trend are produced in the final analysis only by
price movement.

Volume simply affords collateral
evidence which may aid interpretation of otherwise doubtful

 (We shall have much more to say in later
chapters about volume in specific relation to other technical

"Lines" May Substitute for Secondaries—A Line in Dow
Theory parlance is a sidewise movement (as it appears on
the charts) in one or both of the averages, which lasts for
two or three weeks or, sometimes, for as many months, in
the course of which prices fluctuate within a range of approximately 5% or less (of their mean figure). The formation
of a Line signifies that pressure of buying and selling
is more or less in balance.

Eventually, of course, either the
offerings within that price range are exhausted and those
who want to buy stocks have to raise their bids to induce
owners to sell, or else those who are eager to sell at the
"Line" price range find that buyers have vanished and that
in consequence they must cut their prices in order to dispose
of their shares. Hence, an advance in prices through
the upper limits of an established Line is a bullish signal
and, conversely, a break down through its lower limits is a
bearish signal. Generally speaking, the longer the Line (in
duration) and the narrower or more compact its price
range, the greater the significance of its ultimate breakout.


Lines occur often enough to make their recognition essential
to followers of Dow's principles. They may develop at
important tops or bottoms, signalizing periods of distribution
or of accumulation, respectively, but they come more
frequently as interludes of rest or consolidation in the
progress of established Major trends.

Under those circumstances, they take the place of normal Secondary

A Line may develop in one average while the other
is going through a typical Secondary reaction.

It is worth noting that a price movement out of a Line, either up or down, is usually followed by a more extensive additional move in the same direction than can be counted on to follow
the "signal" produced when a new wave pushes beyond the limits set by a preceding Primary wave.

The direction in which prices will break out of a Line cannot be
determined in advance of the actual movement.

The 5% limit ordinarily assigned to a Line is arbitrarily based on experience; there have been a few slightly wider sidewise
movements which, by virtue of their compactness and
well-defined boundaries, could be construed as true Lines.
(Further on in this book, we shall see that the Dow Line is,
in many respects, similar to the more strictly defined patterns
know as Rectangles which appear on the charts of individual

Only Closing Prices Used—Dow Theory pays no attention
to any extreme highs or lows which may be registered
during a day and before the market closes, but takes into
account only the closing figures, i.e., the average of the
day's final sale prices for the component issues. We have
discussed the psychological importance of the end-of-day
prices under the subject of chart construction and need not
deal with it further here, except to say that this is another
Dow rule which has stood the test of time. It works thus:
Suppose an Intermediate advance in a Primary uptrend
reaches its peak on a certain day at 11 a.m., at which hour
the Industrial average figures at, say, 152.45, and then falls
back to close at 150.70. All that the next advance will have
to do in order to indicate that the Primary trend is still up is
register a daily close above 150.70. The previous intraday
high of 152.45 does not count.

 Conversely, using the same
figures for our first advance, if the next upswing carries
prices to an intraday high at, say, 152.60, but fails to
register a closing price above 150.70, the continuation of the
Primary Bull trend is still in doubt.

In recent years, differences of opinion have risen among
market students as to the extent to which an average
should push beyond a previous limit (top or bottom figure) 
in order to signal (or confirm or reaffirm, as the case may
be) a market trend. Dow and Hamilton evidently regarded
any penetration, even as little as .01, in closing price as a
valid signal, but some modern commentators have required
penetration by a full point (1.00).

We think that the
original view has the best of the argument, that the record
shows little or nothing in practical results to favor any of
the proposed modifications. One incident in June of 1946,
to which we shall refer in the following chapter, shows a
decided advantage for the orthodox "any-penetrationwhatever"

A Trend Should Be Assumed to Continue in Effect Until
Such Time as Its Reversal Has Been Definitely Signaled—
This Dow Theory tenet is one which, perhaps more
than any other, has evoked criticism. Yet when correctly
understood, it, like all the others we have enumerated,
stands up under practical test.

What it states is really a probability. It is a warning against changing one's market position too soon, against "jumping the gun." It does not imply that one should delay action by one unnecessary minute once a signal of change in trend has appeared, but it expresses the experience that the odds are in favor of the man who waits until he is sure, and against the other fellow who buys (or sells) prematurely. These odds cannot be
stated in mathematical language such as two-to-one or
three-to-one; as a matter of fact, they are constantly changing.
Bull Markets do not climb forever and Bear Markets always
reach a bottom sooner or later. 

When a new Primary
trend is first definitely signaled by the action of the two
averages, the odds that it will be continued, despite any
near-term reactions or interruptions, are at their greatest.
But as this Primary trend carries on, the odds in favor of its
further extension grow smaller. 

Thus, each successive reaffirmation of a Bull Market (new Intermediate high in one average confirmed by a new Intermediate high in the other) carries relatively less weight. The incentive to buy, the prospect of selling new purchases at a profit, is smaller a Bull Market has been in existence for several months it was when the Primary uptrend was first recogmzed,
butthis twelfth Dow tenet says, "Hold your posU.on pending
contrary orders."

A corollary to this tenet, which is not so contradictory as it
may at rsVt seem, is: A reversal in trend can occur-anylm*
Tfter that trend has been confirmed. Th,s can be taken
simply as a warning that the Dow Theory investor must
wTtch the market constantly so long as he has any comrmtment
in it.


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