Dow Theory (Part 1)
Over the last few months, I’ve discussed my investment philosophies using all sorts of metaphors and descriptions. Little did I know that many of these ideas have already been distilled into a very eloquent theory known as The Dow Theory. Had I been more well versed in these ideas earlier, it might have been a lot easier for me to describe longterm continuums (Dow’s “primary trend”), short term trend reversals (Dow’s “secondary movements”), and the natural basing and climbing periods (Dow’s stages of stock market movement/wave analogy) of a stock.
The Dow Theory was conceived by Charles Dow during his analysis of market price action in the late 1800s. A modest man, he never attempted to publish these theories and it was not until after his death in 1902 that S.A. Nelson and William Hamilton refined his writings and created what we today refer to as Dow Theory. The work was also carried even further after the Great Depression by Robert Rhea who published the aptly titled book, The Dow Theory
Dow Theory Background and Assumptions
So, what is the Dow Theory? Basically, it’s a set of principles and tenets that describe the general motions of the stock market and individual stocks. It’s not necessarily a path to beating the market, but a guide for understanding the underlying mechanisms involved. It’s based on two simple assumptions:
- It is impossible to manipulate a stock’s primary trend.
- The market discounts all presently available information.
These two assumptions basically imply many things that we believe about the stock market. The first assumption implies that company performance will ultimately guide the company’s stock in one direction or another. Or, as Ben Graham put it, “In the long run, the stock market is a weighing machine.” No amount of traders shorting, boiler room pushing, or any other kind of shenanigans can move a stock off its ultimate direction. The market reflecting all available information implies that event risk will create volatility and create secondary movements against the primary trend of a stock. It also implies that smoothing stock movements with moving averages could help to distill the true value the market puts on the company.
Market Movements in the Dow Theory
The Dow Theory breaks down market movements into three types: primary trend, secondary movements, and daily movements. The analogy is that of a rising or receding tide. The tide moves in one direction but includes waves which come in and out. And, on each wave are ripples of current which move in any direction they please. To the Dow Theorist, the key is to identify which direction the tide is moving and to effectively anticipate the ebb and flow of each wave in the rising (or receding) tide. Ripples are thought to be random and, while important to observe, difficult or impossible to predict.
Stages of Market Movement
Again, in an eerily similar approach to market movement, Dow Theorists distill bull and bear cycles into three stages each.
Bull Stage 1: Accumulation – The stock finds a bottom and begins what appears to be a reaction rally. In fact, this is value buyers and “smart money” beginning to move back into the stock as a result of valuation too low to pass up or improving company fundamentals. Stock advances quietly towards a previous relative high. (Often also described as a base)
Bull Stage 2: Big Move – Stock breaks past previous relative high and public investors identify it as a great buy. This move is usually also followed by continuously improving company performance. Most of the stock’s gain will happen in this stage.
Bull Stage 3: Excess – As always, market participants exhibit “irrational exuberance,” expectations exceed reality and valuations begin climbing only through multiple expansion.
Bear Stage 1: Distribution – The “smart money” begins to sell and realize profit. Most other market participants remain bullish. There might be a slight correction that many interpret as a blip rather than a reversal and there are usually enough buyers to push the market back towards its highs as speculators give a last gasp attempt to squeeze profits out of the stock. There will likely be decreased volume despite increasing prices in this stage.
Bear Stage 2: Big Move – Downtrend begins as the stock falls past crucial support and a series of lower lows and lower highs forms.
Bear Stage 3: Despair – Participants have flooded out of the stock and driven valuations below reasonable (pessimistic) expectations. With enough investors having exited and sold off their shares regardless of positive or negative news, the cycle begins again.
The Dow Theory typically refers to these primary trends as being truly long periods correlated directly with positive or negative performance by the economy or a company in question. I also believe that this cycle can be applied to intermediate term stock growth when a company does not find its performance deteriorating. The bull trend is roughly similar, but rather than a bear trend with a big move down, you will find a slight move down and roughly lateral trading on moderate volume (the base) during a period when earnings remain strong, but maybe below unreasonable estimates. As the market gets its bearings straight and realizes that the company has continued to perform, the bull cycle begins again.
In future posts, we’ll discuss the signals and trend identification tools used by Dow Theorists to attempt to time the market.
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