Dow Theory Explained - Part 2

Price Action Determines the Trend Bullish indications are given when successive rallies penetrate peaks while the trough of an intervening decline is above the preceding trough. Conversely, bearish indications come from a series of declining peaks and troughs.

It is essential to establish that the secondary reaction has retraced at least one-third of the preceding primary movement, as measured from the termination of the preceding secondary. The secondary should also extend for at least 3 to 4 weeks. Vital clues can also be obtained from volume characteristics and from an assessment of the maturity of the prevailing primary trend.

The odds of a major reversal are much greater if the market has undergone its third phase, characterized by speculation and false hopes during a primary upswing or about of persistent liquidation and widespread pessimism during a major decline. A change in the primary trend can occur without a clearly identifiable third phase, but generally such reversals prove to be relatively short lived. On the other hand, the largest primary swings usually develop when the characteristics of a third phase are especially marked during the preceding primary movement.

The Averages Must Confirm One of the most important principles of Dow theory is that the movement of the Industrial Average and the Transportation Average should always be considered together (that is, the two averages must confirm each other). The need for confirming action by both averages would seem fundamentally logical, because if the market is truly a barometer of future business conditions, investors should be bidding up the prices both of companies that produce goods and of companies that transport them in an expanding economy. It is not possible to have a healthy economy in which goods are being manufactured but not sold (that is, shipped to market).