Saturday, 31 March 2012

ANALYSIS STOCK TRENDS, Chapter 4, The Dow Theory In Practice


Robert D. Edwards
John Magee

Chapter 3

The Dow Theory

At this point, the reader, if he has little previous knowledge of
the stock market, may be suffering a mild attack of mental indigestion.
The Dow Theory is a pretty big dose to swallow at one

We departed deliberately in the foregoing chapter from the
order in which its principles are usually stated, in an effort to make
it a little easier to follow and understand. Actually, not all of the
twelve tenets we named are of equal import.

 The essential rules are
contained in 2, 3,4, 5, 8,10 and 11. Number 1 is, of course, the basic
assumption, the philosophical justification for these rules. The
other points (6, 7, 9, and 12) furnish "background material," as the
news reporters might put it, which aid in interpretation. Theoretically,
one should, by strict adherence to the essential rules alone,
accomplish just as much as he could with the added collateral

But the utilization of Dow Theory is, after all, a matter of interpretation.
You may memorize its principles verbatim and yet be
confounded when you attempt to apply them to an actual market

We can better organize our knowledge of the Theory and
acquire some understanding of its interpretation by following
through a few years of market action and seeing how it looked at
the time through the eyes of a Dow Theorist. For this purpose, we
may well take the period from late 1941 to the beginning of 1947,
since this covers the end of one Bear Market, an entire long Bull
Market and part of another Bear Market, and includes examples of
most of the market phenomena with which the Dow Theory has to

the wishful thinkers again talked Bull Market. There is an unfortunately
tendency in "the street" to overstress any such divergence,
particularly when it can be twisted into a favorable sign.
The fact is that, in Dow Theory, the refusal of one average to confirm
the other can never produce a positive signal of any sort. It has
only negative connotations.

 Divergences sometimes occur at reversals
in the Major trend—there have been several instances in
market history of which perhaps the most remarkable occurred
way back in 1901 and 1902, and we shall soon inspect another—
but they also occur with at least equal frequency at times when no
Major reversal is developing, and the instance we are here discussing
was one of the latter.


So the situation at the end of May in 1941 was precisely the
same to the Dow Theorist, insofar as the Major trend was concerned,
as it had been on February 14. The June-July rally topped
out in the Rails at 30.88 on August 1, and in the Industrials at
130.06 on July 28 (compare these figures with their 1940 November
highs) and prices then declined at an accelerating pace which culminated,
temporarily, in the "Pearl Harbor" panic. This took the
Industrial average below its previous Bear Market low (111.84 on
June 10, 1940), although the Rails again did not follow. They had,
however, by this time broken below their previous (February 14)
Intermediate bottom by a liberal margin.

The next period of importance began in April, 1942. We can
skip any detailed chart of the months between December and
April because they posed no Dow Theory problems. After a Minor
rally in the Rails in January, prices simply drifted lower and lower,
but it was increasingly evident that trading volume did not expand
on the dips (minor declines).

 Liquidation was drying up; the
boardrooms were void of customers; the atmosphere was typical
of the last stages of a Bear Market.

developed, when, after rallying for only seven days, the Railroad
index began to slip off while the other average kept right on going
up. Trading activity remained at a low ebb (there was no sustained
volume increase, in fact, until late September).

 On June 1, the Rails
dropped to another new low and on the 2nd closed at 23.31. On
June 22, it looked as though the Industrials were going to be
pulled down again, but only a few days later, the best rally in
months got started, taking the Industrials to new highs and more
than recovering all of the April-May loss in the Rails. Activity also
speeded up briefly, with one day registering a greater turnover
than the market had enjoyed in any session since early January.
Signs of Major Turn

Again the Dow Theorists were very much on the alert. An advance
of Intermediate proportions was obviously under way. Until
proved otherwise, it had to be labeled a Secondary within the Bear
Market which was still presumably in effect, but that Major
downtrend had by now run for nearly three years—nearly as long
as any on record—and its last decline had shown no selling pressure
whatever, simply a dull drift. This presumed Secondary
might turn out to be, instead, a new Primary; hopes for such a
denouement had been blighted twelve months earlier under somewhat
similar circumstances, but this time prices were lower and
there was a different "feel" to the market. The general news offered
little encouragement, but the Dow Theory does not concern
itself with any news other than that made by the market itself
(which discounts all other kinds of news).

 In any event, there was
nothing to do but wait and see—let the market, in its own time
and way, state its own case.

It was necessary now to relabel the up move from April-June
to November of 1942 as the first Primary swing in a Bull Market.
The decline of the Rails from November 2 to December 14 was
now recognized as the first Secondary within that Major trend.
We may turn back for a moment at this point to comment on
the performance of the Rail index in June, 1942. Because it held
then above its low of May, 1940, some commentators have maintained
that the Bull Market should really have been dated from
that former year as representing the last "confirmed" lows. This
strikes us as rather impractical hair-splitting. Regardless of the 1.17
higher level in the Rail average in June, 1942, a genuine Bull move
did not start until that time.

We suspect that before many years
have passed, Dow Theorists will have occasion greatly to regret
the importance which has since been assigned to the Rails' "failure
to confirm" in the spring of 1942. 

Remember, such a divergence
does not and cannot produce a positive signal; at the time of its occurrence,
it can serve merely to negative or cast in doubt the implications
of the other average; only subsequent action in the opposite
direction can establish the existence of a change in trend. If
the Rails' decline in May, 1942 had carried them below 22.14, but
their subsequent action had followed the course which it actually
did, point for point but at a lower level, a Bull Market signal
would nevertheless have been given at the very same time, not one
later and not one day sooner.

Moreover, a divergence does not necessarily imply that a move
of consequence in the opposite direction will ensue. We have already
examined one comparable instance (in the spring of 1941)
which resulted otherwise. 

Logically, also, if a failure to confirm
such as occurred in 1942 is to be taken as an indication of a turn in
trend, then its opposite, i.e., confirmation or reaffirmation by both
averages, should argue with equal force against a turn in trend. Yet
the simple truth is that many more Major reversals have come
when the averages were in agreement than when they were divergent.
We have no wish to belabor the point or waste the reader's
time but we do feel that he should be warned against the wishful
thinking which every "failure to confirm" seems to inspire when
the market is in a Bear trend.

To return to our history, the averages closed at 125.88 and
29.51, respectively, on the day following our conclusive Bull
Market signal in February, 1943. Theoretically, there is where an
investor who followed the Dow Theory strictly would have
bought his stocks. (Those who were satisfied that the Primary
trend was up in November, 1942, bought with averages around
114.60 and 29.20.) It was reasonable to assume that this Bull
Market, which as yet showed few of the usual characteristics of the
second phase and none whatever of the third phase, would continue
for some time to come. The next four months produced no
market developments that required interpretative attention, and
we can move on to the events of July. Figure 6 charts the action
from July 1,1943 to January 31,1944.

The First Correction

After closing at 145.82 on July 14, 1943, the Industrial average
drifted off. The Rails pushed up to a new high (38.30) ten days
later, but the Industrials refused to join in the rally and then both
indexes cracked down sharply for seven sessions. Turnover increased
and the decline was the greatest that had occurred in the
Bull Market up to that date, but everyone realized that the market,
after several months of quite persistent advance, 

Bull Trend Reaffirmed
The situation remained in doubt (but subject always to that
basic presumption of the Dow Theory which we named as Number
12 in the preceding chapter) until June 15, 1944, when the Industrials
finally came through to close at 145.86. It had taken them
four months to confirm the Rails, almost a full year to reaffirm the
Primary uptrend. The effect of this "signal" on traders was electric;
trading volume increased by 650,000 shares on the following day
as prices jumped another full point.

The following twelve months need no detailed discussion as
they produced nothing in the way of market action to give a Dow
Theorist any concern. Prices drifted off irregularly for nine weeks
after mid-July but their net loss was of minor proportions, and
they then climbed with only brief interruptions to 169.08 in the Industrial
index on May 29,1945 and 63.06 in the Rail index on June
26,1945. We should take a brief look at the period which followed,
not because it illustrates anything new in our study, but because it
takes in the surrender of Japan and the end of fighting in World
War II.

Figure 7 covers the seven months from May 1 to November 30,
1945. The Industrials held steady for four weeks while the Rails
were making the spurt to their June 26 top.

 On June 28, with nothing
in the newspaper headlines to account for such a radical trend
change, prices broke sharply and turnover climbed to nearly three
million shares, the highest day's total for the Bull Market up to
that time. But the Industrial average gave ground reluctantly
thereafter, and by June 26, at 160.91, had given up less than 5% of
its top price. The Rails shook down rapidly, however.

The Rails Falter
Before we go on with our examination of the market action
here, it is interesting to note that, up to this point, the Rail average
had been the "hero" of our story. Starting with its refusal to go
down to a new Bear Market low in June of 1942, it was the spearhead
of each important advance, had staged the most spectacular
rallies, had gained 170% in value as compared with the Industrials'
82%. In retrospect, the explanation is obvious: The railroads were
the chief business beneficiaries of the war. They were rolling up
profits, paying off indebtedness and reducing their fixed charges
at a rate unheard of in this generation (and probably never to be
seen again). While the "public's" eye was on the traditional and
better publicized "war industries," the market began as far back as
Pearl Harbor shrewdly to appraise and discount this unprecedented
harvest for the Rails. But from here on, the picture changes
and the Rails become the laggards. As we look back now, it is just
as obvious that, with equal shrewdness, the market began in July
of 1945 to discount a change in their fortunes. An illuminating
demonstration of the basic assumption (Tenet Number 1) in Dow

Turning back to our chart, prices began to push up again with
renewed vigor after August 20. Both averages had experienced a
Secondary reaction and now Dow Theorists had to watch closely
to see if the Primary uptrend would again be reaffirmed by their
going to new highs. 

The Industrials "made the grade" when they
closed at 169.89 on August 24, but the Rails had much more
ground to recover and were running into offerings as they came
up in succession to each of the Minor bottom levels of their June-
August downtrend (a phenomenon to which we shall devote some
attention later on in the chapter on "Support and Resistance").

The Spring of 1946

The market went through a minor setback in late December—a
development which has come to be expected as the normal pattern
for that month and which is usually attributed to "tax selling"—
and stormed ahead again in January, 1946. Daily volume on
January 18 exceeded three million shares for the first time in more
than five years. During the first week of February, prices
"churned" with little net change. Extreme high closes were
registered during this period by the Rail average at 68.23 on
February 5, and by the Industrial average at 206.97 on February 2.
On February 9, 

the 13th to the 16th, and then broke in a selling wave that ran to a
climax on February 26 with closings at 60.53 and 186.02, respectively.
The loss in the Industrials was the greatest in points (20.95)
they had suffered during the entire Bull Market; in the Rails, it was
exceeded only by their July-August decline of the previous year. It
amounted to a little more than 10% in the former and 11% in the
latter, and gave up a little less than half of their advances from the
1945 summer lows. The decline was three weeks old on February
26. It was an unqualified Intermediate—in Dow Theory a Secondary
reaction presumptively within the still existing Major

Labor troubles were dogging the steel and motor industries in
1946 from early January on, and a coal strike was looming. The
February break was attributed to those news developments, but
the ruling cause was more likely the discontinuance of margin
trading. The Federal Reserve Board had announced in January that
after February 1, stocks could be bought only for full 100% cash.
The late January up-fling was featured by the "little fellow" seizing
his last chance to buy on margin. (Those who participated in
this scramble will doubtless regret it for a long time yet to come.)
Professionals seized the opportunity to unload their trading commitments,
but the "little fellow" was now temporarily out of
funds; his brokerage account was quickly "frozen." Under the circumstances,
as we look back, it is amazing that a more extensive
panic did not then eventuate.

But the Dow Theorist was not concerned with causes. The Bull
Market had been reaffirmed by both averages in early February,
canceling all previous "signal" levels. Bullish forces were still evidently
in effect because the February 26 lows held and prices
began to recover. 

The Industrials came back quickly, and by April
9 had closed in new high ground at 208.03. The Rails dragged.
When the market showed signs of weakening at the end of April,
the Rail average was still nearly 5 points below its early February
high. Was this another "failure to confirm" to worry about?

Final Up Thrust
The late February bottoms were now the critical points on the
downside; if both averages should decline below the Intermediate
low closes then recorded, before the Rails could make a new high
above 68.23 (in which event the bullish signal of the Industrials
would be canceled),

 a Bear Market would thereby be signaled. But,
despite a miner's strike and an imminent rail workers' strike, the
market turned firm again in mid-May and put forth a surprising
rally which swept the Industrial index up to 212.50 on May 29,
1946—a new Bull high by nearly 6 points. The Rails failed in May
by only .17 to equal their February high close, slid back a trifle and
then pushed through at last on June 13 to close at 68.31, thereby
confirming the Industrials in their announcement that (as of that
date) the Primary trend was still Up. The February lows (186.02
and 60.53) now ceased to signify in Dow Theory, but keep those
figures in mind because they are involved in an argument which
raged among Dow students for months thereafter.


Figure 9 overlaps the preceding picture, taking up the market's
action on May 4 and carrying it forward to October 19,1946. Trading
volume, it may be noted, in late May and early June did not
come up to the levels of either the late January to early February
top or the late February bottom; the market appeared to be losing
vitality, an ominous, although by no means, decisive manifestation.
Prices began to fall off rapidly immediately after the Rail confirmation
on June 13. The Industrials rallied for two weeks in early
July, but the Rails continued to decline; the Industrials broke again
on July 15 and the two averages continued their slide until they
stood at 195.22 and 60.41 at the close on July 23.


There, as it subsequently developed, was the end of that particular
Intermediate swing—one which in accord with our Rule 12
had to be labeled a Secondary reaction in a Bull Market until
proved otherwise. The market swung up again. It climbed slowly
and steadily, but with turnover running well under a million
shares, until exactly three weeks later

The Bear Market Signal
That the situation was critical was evident in the volume chart.
Ever since the end of May, turnover had tended not only to increase
on the declines but, what was much more important, to dry
up on the rallies. Compare Figure 9 with 7 and 8, and you can see
how conspicuous this phenomenon had become by mid-August.
Prices did turn down, with activity increasing on the breaks, and
on August 27, the closing prices—191.04 for the Industrials and
58.04 for the Rails—told a sad story. The averages had spoken: a
four-year Bull Market had ended, and a Bear Market was under
way. A Dow investor should have sold all his stocks on the following
day (at approximately 190 and 58 in terms of the two

To clear the record, it was necessary for the Dow Theorist now
to go back and mark the May 29 and June 13 highs in the Industrials
and Rails, respectively, as the end of the Bull Market. The
June-July decline then became the first Primary swing in the new
Bear trend, and the July 23 to August 14 advance became the first
Secondary recovery within the Major downtrend.

 A second
Primary swing was now in process of development.
You will have noted in the foregoing that a Bear Market was
signaled as soon as both averages penetrated their July 23 lows.
Lot us return now and take up that argument which we mentioned
on the preceding page. Some students of Dow Theory refused to
recognize the new high of June 13 in the Rail average as a decisive
reaffirmation of the Bull trend. The previous close should be bettered
by at least a full point (1.00), many argued

The market did, of course, proceed to break its February lows,
and by that time, the panic (second phase) was on. Obviously, in
this case, the orthodox "any-penetration-whatever" school had all
the best of it; they had sold out at least 13 points higher up in
terms of the Industrial index (at least 6 in the Rails). Six weeks
later, on October 9, 1946 to be exact, this second Primary Intermediate
swing ended at Industrials 163.12, Rails 44.69, and another
Intermediate recovery move started.


Before closing this history of six years of Dow Theory interpretation,
we might note that the June 13 high in the Rail average
furnishes a perfect illustration of the rule that a trend can change
any time after it has been confirmed or reaffirmed, also of the
diminishing odds in favor of continuance with each successive
reaffirmation of the Primary trend.


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