Let’s get into the tenets of Dow Theory. We have 6 principles to cover here.
1. The Averages Discount Everything (Except “Acts of God”)
During Dow’s time, there was considerably less liquidity & price manipulations were rampant. By creating an aggregate of 30 stocks, the effect of individual odd moves were minimized.
Let’s discuss with an example how averages discount everything. Suppose, there is an intentional accounting malpractice on part of the management of a corporation. Depending upon the degree of wrong-doing and subsequent information flow pyramid, an analyst should be able to identify an excess supply of the stock as compared to its demand in the market. This imbalance will manifest itself as a downtrend on the chart which should be visible to an experienced pair of eyes. Now, the reason for such excess supply & resulting downtrend may not be apparent, but nevertheless the analyst is likely to recommend selling the stock, if not selling short. The actual news of fraud will come to fore at a much later date & the reasons could be known only then.
In true sense, the Averages only ‘try’ to discount every information, news & views of the participants within itself. The knowledgeable & wealthy investors in their pursuit of profit take position & push market to a more efficient state. This creates a trend in prices. To assert that Averages discount “Everything” is a gross oversimplification of fact as in that case market would have turned perfectly efficient.
By the term, acts of God, we mean price shocks. Let’s have a quick chat on this topic. Price shocks are completely random & unpredictable events of large magnitude, like terrorist attack of September 2001. Many trading careers have come to an abrupt end due to such unfortunate events. Therefore survival strategies are of utmost importance during such eventualities and position size is to be considered very carefully to avoid overtrading as these events can never be discounted beforehand. Last but not the least, if a price shock generates favorable price action (eg. a short position in equities & long in gold before twin tower attack) it is safe to attribute it to luck than skill.
2. Classification of Trends
This one is the most important aspect of Dow Theory and stepping stone of building technical trading systems. We are outlining the broad principles in this article.
Market movements are seen to be analogous to tidal waves. During the time of high tide each wave covers a bit more land than its previous one and consequently the sea gradually makes in way to the shorelines. In the similar manner, a bull market sees waves of buying frenzy & each enthusiastic buying phase puts prices a bit higher than its previous phase. This is manifested on chart as a higher top & higher bottom formation. We call this an uptrend. Moreover, just like a high tide lifts all vessels floating on it, a bull market also lifts all issues without looking at quality (and makes everybody feel good). The reverse happens during a bear market when phases of selling frenzy pushes price a bit lower than the previous phase, just like receding waves during low tides. We call this a downtrend & it can be identified on chart as series if lower tops & lower bottoms.
In our next article, we shall continue on this topic & take a look at how large price movements can be broken into parts for better analysis & trading decisions. We shall also consider the remaining tenets of Dow Theory.