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Part 6 - The Dow Theory

Monday 27 August 2012

The legend of technical analysis, Charles Dow, is the father of what is popularly known as the "Dow theory". Though developed more than a century ago, his theory is used even today by analysts to evaluate market behaviour.

A.J. Nelson, a friend of Charles Dow, formalised the theory for the purpose of analysis and predicting market behaviour and named it the "Dow theory". Today, the Dow theory is a basic tool for the purpose of analysing and predicting market behaviour and stock prices.

The Dow theory was developed to analyse the movement of indices and was based on the 'closing' price of the indices. It did not use other variables such as 'open', 'high' or 'low'. However, as the concept remains the same, the theory can be extended to explain and predict even individual stock prices. Now, we will have a look at a few of the assumptions behind this theory..

Assumptions

1) The primary trend or the broad direction of the price movement cannot be influenced by external factors. Thus, no one can manipulate the overall rising or falling trend in prices in the long-term (long-term is defined as a year or so). In such a scenario, the market is termed as a 'bull market' or a 'bear market' respectively. However, in the short-term, it is possible that the price levels are manipulated. Short-term consists of a period lasting up to a maximum of 3-4 months.

2) The market discounts everything. In other words, stock prices exhibit their true value as all the information about the future earnings, inflation, economic parameters, etc. is already discounted in the stock prices. In fact, this assumption is the very basis of technical analysis.

3) The theory is not foolproof. In other words, the theory only helps to understand the broad price movements of indices or stocks. It cannot accurately predict the likely price targets or when the share price reaches the peak or the bottom.

Trends
The Dow theory explains that there are three types of trends applicable in a market. These trends are known as primary trends, intermediate trends and short term trends. A primary trend is the broad upward or downward movement and lasts for over one year. It shows the market movement over the long term. An intermediate trend lasts for a period of two to three months. Short term trends last for a period ranging from two to three days to a maximum of a week or so. Thus, in a given market, these three trends are always in operation.

Primary trend
This is the long-term direction in the price movement and lasts for a year or a number of years. It also consists of three phases, wherein each phase is interrupted by an intermediate trend reversal lasting up to two to three weeks. This intermediate trend takes away 33-66 per cent of the earlier price movements, upward or downward. Thus, in the case of an upward movement, the intermediate trend will lead to an erosion of valuation to this extent and vice versa for a downward long-term trend. Each bull as well as bear market leads to the formation of three distinct peaks and bottoms, respectively. In the case of a rising market, factors such as confidence in business prospects, better corporate earnings and a bull frenzy come into play. In the case of a downward movement, factors such as loss of hope, a downfall in business performance and distress selling would come into play. The primary trends (both in case of a rising or falling market) can be explained by way of the following figures:


Similarly, in the case of a broadly falling trend, the three phases of a bear market would be as follows:


Thus, it can be seen that each bull trend and bear trend is made up of three phases, each that lasts for a considerable period of time. In case of a bull run, each new top and bottom is higher than the previous top and bottom. However, in case of a bear run, the scrip witnesses new bottoms and tops which are lower than the earlier ones. This phenomenon explains the behaviour of market movements from the long-term point of view.

Intermediate trend
In case of an intermediate trend, the intermittent price movements would correct the earlier gains or losses made by the scrip. This trend lasts for a period ranging from two to three weeks to a maximum of two to three months and takes away 33-66 per cent of the gain or loss of the earlier period. Thus, in case of a rising trend, the secondary trend will lead to a fall by this extent and in the case of a bear market, it will lead to a gain to this extent. This can be explained by way of the following figure where the primary trend is rising and intermediate trend takes away a portion of the gains made by the scrip:


Short term trend
Short term trends are also known as minor trends and can be witnessed intra day or during a few days. These trends correct the over bought and over sold positions in the scrip caused by reversals made in the intermediate trends. For the purpose of analysis, it makes sense to ignore short-term trends and analyse the primary and secondary trends in prices.

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