The study on stock markets and price movements first published by Charles H. Dow on July 3, 1884 is the most popular and the most quoted of stock market theories and it forms the basis of all technical studies. This theory concerns itself solely with the stock market - the movement of share prices and nothing else. It does not concern itself with facets of the companies concerned such as the competence of the management, the quality of its products and the likes. It deals purely with movements and prices.
Consequently, a criticism that is often leveled at this theory is that the signals are given “too late”. But then, Dow did not intend that his findings be used to forecast movements. His submission was only that share prices move in trends. Once this submission is accepted it can be used as a guide to business trends and with a “touch of salt” extrapolated to predict movements. It is because of this ability that the Dow Theory, as it is popularly known, has remained the basis of technical analysis.
The Dow Theory is based on the submission that the shares of companies in an industry go up or down together. This is why, in technical analysis companies are grouped together by industry. The suggestion is that like must be compared with like; unlikes will differ. Exceptions to the movements of industrial averages, though they do exist, are not very common and do not persist for any length of time. While in periods of depression some share prices may fall faster than others and in periods of boom, some prices may rise faster than others, most shares will move in concert with each other. The exceptions (those that rise or fall faster) too will stabilize in time.
The Dow Theory is based on the following:
a) Average discounts everything
Share prices have taken into account every imaginable factor – political, economic, supply, demand the likes. Whenever a happening occurs, the market discounts it and it is reflected in the price. When Mr. Chandrasekhar submitted his resignation in the first week of March 1991, the Bombay Stock Exchange Sensitivity Index fell by nearly 100 points in one day. This may not seem much today with the volatility that exists in the market. In May 2006, the market fell by over 800 points as it was feared the market was overheated.
b) Market trends
The Dow Theory states that there are three price trends – the primary, secondary and tertiary trend and that these occur within the market place at the same time. Before one goes any further, it is important to look at two basic factors – uptrend and downtrend. An uptrend exists so long as each successive price rally high and is higher than the previous rally and each successive rally low is higher than the one before. A downtrend is exactly the opposite. This definition of uptrend and downtrend forms the basis of trend analysis.
With regard to the three trends, the most important is the primary trend. It is a broad-based upward or downwardswing usually lasting for a year to several years. It is believed to reflect the basic mood in the market and consequentlyfor the proponents of this theory, the primary trend is the basis for successful investing. In the uptrend each new peakis higher than the earlier one. In the downtrend each low is below the previous one. A discerning investor, once heestablishes that an upward trend has started would buy and buy shares until he receives a clear indication that thetrend has reversed. The secondary or intermediate trend represents corrections in the primary trend and usually lastsfor a month to around three to four months. The corrections reverse about a third to two thirds of the earlier trend. Amore aggressive investor would trade normally in the secondary trend.
The minor or tertiary trend lasts from a fewhours to less than a month (usually 20 days) and accounts for short term price movements. These are for the traderthe man who is in the ring – not for long term investors.The theory symbolizes fluctuations in share prices to tides, waves and ripples. The mood of the sea – the strength ofthe tide – is measured by the rise or fall in the prices. As long as the peak of each wave is higher than the previouspeak or the trough is higher than the earlier one, it is assumed that the tide is rising. In a falling tide, the reverse is true.The peak is lower than the earlier peak and the trough is lower than the earlier trough.
Trends are useful in forecasting. It is useful to know how the trends are moving; where the trends have gone upto andwhere it is likely to go to. As there can be several, a discerning investor should be careful in the choosing of trends.
C) Trends
Each trend has three clear phases. In the first instance, in an upward or bullish market, the first phase is known as theaccumulation phase. This is the time when discerning investors or the early birds begin buying as they perceive theprices will begin to move up. In the second phase, trend followers begin to notice an upward or bullish trend and beginto start buying. Prices begin to improve and advance very fast and word begins to get around. In the third and finalphase, the general public everyone begins to buy shares and prices begin to soar. It is at this last stage that thediscerning early birds who had bought shares at low prices begin to sell them. In a bearish phase, astute investorsperceive the markets will fall and begin selling. They are joined at the second stage by the trend watchers. In the laststage there is panic and everyone sells. A classic example occurred in 1989 when V.P. Singh became Prime Minister.The prices of companies in the Reliance fold plummeted from a high of around Rs.200 to a low of below Rs.60 pershare.
d) Averages conform to each other
The theory submits that averages in general move in concert. The averages in different industries will move up or low at around the same time. No major bear or bull market movements will occur unless averages also move in a similar manner. This is true. In the bull boom of 1990, the prices of all shares and in different industries soared together. At the end of 1990, they fell together too.
e) Volume confirms trends
Volumes of the number of shares sold or bought will confirm the trend. In a bullish market, more and more shares will be bought, whereas in a bearish market, the volumes of shares sold will be on the ascendant.
f) Trends will continue till there are clear indications that it is changing
This suggests that until there is a clear indication that a trend is changing, one should assume that it is continuing. If the market is bullish one should not sell before one is certain that the trend has changed and prices are about to fall. Similarly one should not begin to buy in a bear market until one is sure that there are clear indications or signals that the prices are beginning to increase. This rule warns against one changing positions too soon. It recognizes this and expects investors to realize that nothing remains the same. Prices will go up and it will go down. It never remains stationary. Booms or bull markets have to end sometime. So do bear markets. The investor has to watch trends and act when a reversal is clear.
To put the theory into practice is to be able to determine at what stage one should buy and at what stage one should sell.
Still it has to be accepted that the Dow Theory has proved itself to be a good indicator of price movements and the basic premises of the theory are logical and reasonable. It is because of this that this theory is the cornerstone of technical analysis and until one understands and accepts this, technical analysis would escape him.