Dow Theory

Dr Saif Siddiqui

Introduction

More than 100 years old, Dow theory remains the

foundation of technical analysis.

Dow theory was formulated from a series of Wall

Street Journal editorials

Authored by Charles H. Dow, from 1900 until

the time of his death in 1902.

Introduction

These editorials reflected Dow’s beliefs on

how the stock market behaved and

how the market could be used to measure the

health of the business environment.

Due to his death, Dow never published his

complete theory on the markets,

Introduction

Some important contributions to Dow theory

William P. Hamilton's "The Stock Market

Barometer" (1922),

Robert Rhea's "The Dow Theory" (1932),

E. George Schaefer's "How I Helped More Than

10,000 Investors To Profit In Stocks" (1960)

Richard Russell's "The Dow Theory Today"

(1961).

Introduction Dow believed that

the stock market is a reliable measure of overall

business conditions

By analyzing the overall market, one could

accurately gauge those conditions

and identify the direction of major market trends

and the likely direction of individual stocks.

Introduction

Dow first used his theory to create

The Dow Jones Industrial Index and

The Dow Jones Rail Index

• now Transportation Index

which were originally compiled by Dow for The

Wall Street Journal.

Introduction

He felt that:

These indexes were an accurate reflection of the

business conditions within the economy

Because they covered two major economic

segments: industrial and rail (transportation)

Six basic tenets of Dow theory

The Market Discounts Everything

The Three-Trend Market

The Three Phases of Primary Trends

Market Indexes Must Confirm Each Other

Volume Must Confirm The Trend

Trend Remains in effect until Clear Reversal

occurs

1.The Market Discounts Everything

The first basic premise of Dow theory suggests

All information - past, current and even

future

is discounted into the markets and

reflected in the prices of stocks and indexes.

The Market Discounts Everything

That information includes everything emotions of investors , inflation interest-rate data pending earnings announcements

the only information excluded is that which is

unknowable, such as a massive earthquake.

The Market Discounts Everything

Like mainstream technical analysis, Dow theory is

mainly focused on price.

The two differ in that

Dow theory is concerned with the movements of

the broad markets

• rather than specific securities.

2.The Three-Trend Market

The market tends to move in a general direction,

or trend, it doesn't do so in a straight line.

The market will rally up to a high (peak) and then

sell off to a low (trough), but will generally move in one direction.

The Three-Trend Market

An upward trend is broken up into several rallies, where each rally has a high and a low

For a market to be considered in an uptrend,

each peak in the rally must reach a higher level than the previous rally's peak, and

each low in the rally must be higher than the previous rally's low.

An Upward trend

A downward trend A downward trend is broken up into several sell-

offs, in which each sell-off also has a high and a low.

To be considered a downtrend in Dow terms, each new low in the sell-off must be lower than

the previous sell-off's low and the peak in the sell-off must be lower then the

peak in the previous sell-off.

Downward trend

Three trends

Primary the largest trend lasting for more than a year,

Secondary an intermediate trend that lasts three weeks to three months and

Minor lasts less than three weeks

Primary Trend

In Dow theory, the primary trend is the major

trend of the market,

The primary trend will also impact the secondary

and minor trends within the market.

Primary Trend

Secondary or Intermediate Trend

A secondary trend moves

in the opposite direction of the primary trend, or

as a correction to the primary trend.

An upward primary trend will be composed of secondary downward trends.

In a primary downward trend the secondary trend will be an upward move, or a rally.

Secondary or Intermediate Trend

Minor Trend

Market movement lasting less than three weeks. The minor trend is generally the corrective

moves within a secondary move, or those moves that go against the direction of

the secondary trend.

Minor Trend

3. Three Phases of Primary Trends Primary Upward Trend (Bull Market)

The Accumulation Phase

Public Participation Phase

The Excess Phase

Primary Downward Trend (Bear Market) The Distribution Phase Public Participation Phase The Panic Phase

Primary Upward Trend

The Accumulation Phase The first stage of a bull market is referred to as

the accumulation phase, which is the start of the upward trend.

The accumulation phase typically comes at the end of a downtrend, when everything is seemingly at its worst

The Accumulation Phase

Primary Upward Trend

Public Participation Phase Informed investors entered the market during the

accumulation phase, Negative sentiment starts to dissipate as business

conditions improve As the good news starts to permeate the market,

more and more investors move back in sending prices higher.

Public Participation Phase

Primary Upward TrendThe Excess Phase The smart money starts to scale back its positions,

selling them off to those now entering the market "irrational exuberance".

The perception is that everything is running great and that only good things lie ahead.

This is the time when the last of the buyers start to enter the market

after large gains have been achieved., they are buying near the top.

The Excess Phase

Primary Downward TrendThe Distribution Phase The period in which informed buyers sell (distribute)

their positions. The informed buyers are now selling into an overbought

market It is also the phase in which there is continued buying

by the last of the investors in the market, especially those who missed the big move but are

hoping for a similar one in the near future.

Primary Downward Trend

Public Participation Phase The business conditions in the market gets worse the sentiment becomes more negative as time

goes on. The market continues to discount the worsening

conditions as selling increases and buying dries up.

Primary Downward TrendThe Panic Phase The last phase of the primary downward market tends

to be filled with market panic and can lead to very large sell-offs in a very short

period of time. In the panic phase, the market is filled up with

negative sentiment, including weak outlooks on companies, the

economy and the overall market.

4.Market Indexes Must Confirm Each Other

A major reversal from a bull to a bear market (or vice

versa) cannot be signaled unless both indexes

(traditionally the Dow Industrial and Rail Averages)

are in agreement. If one index is confirming a new primary uptrend but

another index remains in a primary downward trend, it is difficult to assume that a new trend has

begun.

5. Volume Must Confirm The Trend

In an uptrend, volume should increase when the

price rises and fall when the price falls. if volume runs counter to the trend, it is a sign

of weakness in the existing trend. If the market is in an uptrend but volume is

weak ,it is a signal that buying is starting to

dissipate.

6. Trend Remains in effect until Clear Reversal occurs

Traders wait for a clear picture of a trend reversal not to confuse a true reversal in the primary

trend with a secondary trend or brief correction. Unless you can safely conclude, based on the

weight of evidence, that the trend has changed,

you will be trading against the trend.

Current Relevance

Followers can miss out on large gains due to the

conservative nature of a trend-reversal signal. Over time, the economy - and the indexes originally

used by Dow - has changed. The industrial and transportation sectors of the

economy are not the only dominant parts.

Elliott Wave Principle

Introduction The Elliott wave principle is a form of

technical analysis attempts to forecast trends.

It is named after Ralph Nelson Elliott (1871–1948) an accountant who developed the concept in the

1930s He proposed that market prices unfold in specific

patterns, which practitioners today call Elliott waves

Critics argue

Critics argue that

the Elliott wave principle is pseudoscientific*

contradicts the efficient market hypothesis.

* Pseudoscience is defined as a body of knowledge,

belief, or practice that is claimed to be scientific,

but does not adhere to the scientific method lacks

supporting evidence

Overall design

The Wave principle posits

that collective investor psychology (or crowd

psychology) moves from optimism to

pessimism and back again.

These swings create patterns, as evidenced in

the price movements of a market

Interpretation of the Elliott Wave Theory

The is as follows: Every action is followed by a reaction. There are five waves in the direction of the

main trend followed by three corrective waves (a "5-3" move).

A 5-3 move completes a cycle. This 5-3 move then becomes two subdivisions

of the next higher 5-3 wave.

Elliott Wave

Fibonacci series

Fibonacci numbers are a series where each

succeeding number is the sum of the two

preceding numbers.

The first two Fibonacci numbers are defined to be

1, and then the series continues as follows:

1, 1, 2, 3, 5, 8, 13, 21…

As the numbers get larger, the ratio of adjacent

numbers approaches the Golden Mean: 1.618:1.

The Fibonacci Sequence – The Secret to Market Movement

In his second book Nature's Law, Elliott refined

his work to incorporate Fibonacci analysis.

Elliott believed that the wave pattern he

discovered was not the product of random chance,

but of what he considered a "natural law" that

was manifest in different facets of life. 

How does this sequence relate to the market?

In the stock market, the simplest description of a

bear market is a straight line down, one wave.

The simplest description of a bull market is a

straight line up.

R.N. Elliott found that It takes one complete

bear market and one bull market to make a cycle.

How does this sequence relate to the market?

At the simplest level, that is 1 rise and 1 fall, for a total of 2 waves. The bear market subdivides into 3 waves, the bull market into 5, and the total is 8.

When you drop to the next subdivision, you find that a bear market has 13 waves, a bull market has 21, and the total is 34.

1, 1, 2, 3, 5, 8, 13, 21,34…

And so on to infinity: each new number is the sum of the previous two.

Does Elliot Wave Work? Who knows? No two practitioners seem to agree on the wave count, Robert Prechter (the most famous EW practitioner)

made several correct predictions in the 1980’s, For example, in 1985 he predicted that the market

would peak in 1987 (correct), but he thought it would peak at 3686 (± 100 points).

The DJIA actually peaked on 25 August 1987 at 2722.42, more than 960 points lower.