Dow Theory Explained - Part 1

The Dow theory 

In order to interpret the Dow theory correctly, it is necessary to have a record of the daily closing prices of the two averages and the total of daily transactions on the New York Stocks Exchange (NYSE). The basic tenets are as follows

The Averages Discount Everything

Changes in the daily closing prices reflect the aggregate judgment and emotion's of all stocks market participants, both current and potential. It is therefore assumed that this process discounts everything known and predictable that can affect the demand/supply relationship of stocks. Although acts of God are obviously unpredictable, their occurrence is quickly appraised and their implications are discounted

The Market Has Three Movements

Primary Movement. Primary or major trend also know as bull market or bear market, it normally lasting from less than a year to several year.

A primary bear market is a long decline interrupted by important rallies. It begins as the hopes on which the stocks were first purchased are abandoned. The second phase evolves as the levels of business activity and profits decline. The bear market reaches a climax; stocks are liquidated regardless of their underlying value (because of the depressing state of the news or because of forced liquidation caused, for example, by margin calls). This represents the third stage of the bear market.

A primary bull market is a broad upward movement, normally averaging at least 18 months, which is interrupted by secondary reactions. The bull market begins when the averages have discounted the worst possible news, and confidence about the future begins to revive. The second stage of the bull market is the response of equities to known improvements in business conditions, while the third and final phase evolves from overconfidence and speculation when stocks are advanced on projections that usually prove to be unfounded.

Minor Movements. The minor movement has no value to long term investor in the sense of forecasting the market trend because short term movements subject to manipulation up to cetain extent, it typically lasting from a week up to as long as 6 weeks.

Secondary Reactions. A secondary or intermediate reaction normally lasting for more than three weeks to few months, it is a major decline in bull market or advance in bear market.

Occasionally, a secondary reaction can retrace the whole of the previous primary movement, but normally the move falls in the one-half to two-thirds area, often at the 50 percent mark. The correct differentiation between the first leg of a new primary trend and a secondary movement within the existing trend provides Dow theorists with their most difficult problem.

Minor Movements. The minor movement lasts from a week or two up to as long as 6 weeks. It is important only in that it forms part of the primary or secondary moves; it has no forecasting value for longer-term investors. This is especially important since short-term movements can be manipulated to some extent, unlike the secondary or primary trends.