Charles Dow and the Market's Stormy Seas
Hey traders, do you recognize any of these statements?
- The market has three trends.
- The averages must confirm each other.
- Major trends have three phases.
If you answered yes. Congratulations! You get an A in today's trading lesson.
Not sure? No sweat, we've got you covered.
All three of those are key tenets of the time-honored Dow Theory.
Who was Dow?
Charles Dow and his partner Edward Jones founded the venerable Dow Jones & Company in 1882. He also launched the Wall Street Journal and invented the Dow Jones Industrial Average. For over a hundred years, Wall Street traders have relied on Dow Theory to guide investment decisions.
Let's dive in and take a look at these concepts.
The Market Has Three Trends
Dow argued that stock market price movement unfolds in three ways. Dow suggested these market price movements were similar to major ocean tides, waves, and ripples.
Where Do We Stand Now?
- The primary trend (Ocean tide)
- Secondary reactions (Waves)
- Minor trends (Ripples)
- Primary trends can last several years or more. Just pull up a monthly chart of the S&P 500. It's safe to say, the primary trend started at the March 2009 low and that trend is up (for now).
- The secondary trend, or reactions, can last from several weeks to several months. We'll call the S&P 500 secondary trend: neutral-bearish in a correction phase.
- Ripples, or short-term minor trends, can last from several days to several weeks.Since early April, the ripple turned slightly positive for the S&P 500. But, that could change tomorrow.
The Averages Must Confirm Each Other
With this saying, Dow pointed to the Dow Jones Industrial Average and the Transportation Average. He argued that no major bull or bear market signal could occur unless both averages gave the same signal – hence confirming each other.
Why would this even matter? Some have argued that some tenets of Dow Theory are dead. But, others believe it still holds true. After all, the Dow Jones Transportation Average, which is a mix of airline, railroad and delivery company stocks, still is an important indicator relating to the goods that are moved around in our society.
Key Point: Companies still rely on planes, trains, ships and trucks to transport raw materials and deliver finished goods to businesses and consumers. That means Transports matter.
Current market reading: For now, there are no "divergences" – both Dow averages are in a correction phase. But, it's worth watching.
Major Trends Have Three Phases
- Here's an example of a potential divergence: Let's say, the DJIA recovered and hit a new all-time high. But, the Transport Index failed to "confirm" that new high with a new high of its own. That would create a divergence or red flag warning signal that the DJIA rally may have weak legs.
The last Dow Theory tenet we'll look at today, may be one of the most interesting. Dow said that major trends have three phases:
The Bottom Line
- Accumulation Phase – this typically represents institutional or smart money buying in an uptrend.
- Public Participation Phase – This historically occurs when stock prices advance quickly and business news improves.
- Distribution Phase – This is part of the topping process in an uptrend. Uninformed Mom and Pop investors are often late to the party and buy during this period. Speculators are running rampant. Significantly, the smart money who accumulated early in the process are now beginning to distribute (or sell) before others do.
The S&P 500 has advanced for over nine years, making it the second longest bull market in modern history.
Using Dow's description, the ocean "waves" and "ripples" are becoming more dramatic.
We easily could be in a distribution phase and the last leg of the major uptrend since the 2009 low.
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