DOW Theory for Market Timing
The DOW Theory was developed by Charles H. Dow, the founder of the Wall Street Journal and Dow Jones Industrial Index (^DJI). Charles Dow did not use this theory by himself, but after his death, his followers collected and organized the "Dow Theory," which is based on Dow's editorials. Since then, aspects of this theory have been put in many theories of technical analysis. The Dow Theory could be considered to be a first serious step in an attempt to time the market by using tools other then fundamental analysis.
In general, the Dow Theory could be summarized in six notes. Some of these notes might appear obvious for many of today's investors. Yet, you have to remember that this theory was first an attempt to summarize the nature of a stock's price trend in the market and to discover a pattern in price movements. You should bear in mind, as well, that, in Dow's time (a hundred years ago), stock market analysis was undertaken for the long-term trend. There were no intraday traders at that time and the number of speculators was limited. Most of Dow's concepts still can be applied for long-term trends. However, when it comes to short-term trading, you should be careful in applying a hundred year old theory. Below are the six basic concepts of the Dow Theory.
- There are three main market movements: main movement, medium swing and short swing.
Today, in the majority of cases, investors referring to them as long-term, mid-term and short-term trends. With the development of intraday trading, the fourth market moment could be added to this list - intraday trends.
In accordance with the Dow classification, long-term trends may last from less than a year or up to several years. Mid-term trends may last from 10 days up to three months and they are 33-66% retracements from the long-term trends (corrections during bullish long-term trends and recoveries during bearish long-term trends). Short-term trends may last from several hours to a maximum of one month.
Now, you may easily add intraday trends that usually last from 5 minutes to several hours.
- Market trends have three phases: accumulation, public participation and distribution.
Note: Do not be confused by the terminology. As it is now, accumulation and distribution terms are used in volume based technical analysis as separate technical indicators and for volume accumulation measurement.
During the first accumulation phase, traders begin to trade against the general market trend and against the general sentiment. The market may continue to move in the previous direction, but eventually the supply/demand balance is shifted and other traders begin to follow this sentiment.
The second phase is when regular investors participate in the clearly defined trend.
During the third phase, the speculators continue to push the trend in the previous direction until investors who entered/left market in the first stages begin to participate again.
We still may see all of these phases in the long-term trend, but by moving into short-term trends, the role of speculators is growing and, on the intraday level, we have basically only speculators playing against each other.
- News affects the market: like it was a hundred years ago, news affects the market trend. The difference now is only that we have hundreds of times more stocks and thousands of times more different news items, economic reports and financial announcements. Furthermore, the affect that news has on the market trend could last for several hours only. However, strong news like the "Internet bubble" in 2000 and the housing bubble in 2008 may still push a market into a strong down-trend.
- Stock market averages (indexes) confirm each other. As was mentioned above, the purpose of the Dow Theory was to time the long-term trend. If you take a look at the long-term now, you will see that majority of US indexes are moving in similar pattern (as the Dow Theory states). During a long-term bullish market, all indexes are moving up-some stronger and some not. During long-term bearish markets, all indexes are in decline - again some may crash strongly and some may decline modestly.
When it comes to the mid-term and short-term trends, you may see that indexes do not always follow and confirm each other. In the mid-term and short-term, the stock market indexes are more sensitive to the news and events in the industry sectors that they cover. As an example, you may occasionally see S&P 500 financial and NASDAQ 100 indexes moving in different direction in the short-term and sometimes even in the mid-term.
- Trends are confirmed by volume. As was true a hundred years ago, volume remains as the main technical indicator that enables us to track changes in a trend. The difference is that the market is not the same today and volume is analyzed differently now.
A hundred years ago, trading short was not the main trading style and an increase in volume indicated that more investors were coming into the stock market, which apparently creates an increase in demand for stocks and moves prices up.
Today, trading volume is much larger and we have bullish and bearish traders. Now, an increase in volume indicates panic selling or greedy buying, which, as a rule, leads to a shift in the supply/demand balance and a trend reversal.
- A trend continues until there are signals that confirm its end. Bear in mind that in Dow's time, the major part of technical analysis was centered on moving averages, which are lagging indicators.
Considering the current aspects of technical analysis, it would be more correct to state that the trend continues until there are enough investors who believe in this trend and there is no shift in the supply/demand balance. There are two groups of technical indicators - leading and lagging. Leading technical indicators help to define moments when the trend is predisposed to change its direction and lagging indicators (as Dow Theory states) confirm changes in trend.
Despite the fact that the Dow Theory is one hundred years old, it still has basic important concepts that are used by many investors and that may help in performing the first steps in technical analysis. As before, stock market trends move in cycles. As before, an index analysis is very important for every trader and not just for those who trade index derivatives (QQQ, SPY, DIA, etc). Volume-based technical analysis plays a significant role in timing the trend and the technical indicators help to define trend reversals and to confirm trends as before.
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