Chapter 2. --- Dow Theory

“Believe in yourself! Have faith in your abilities! Without a humble but reasonable confidence in your own powers you cannot be successful or happy.”

The dow theory is the oldest method of identifying major trends in stock market. From the earliest days, it was well known that stocks moved up and down together. The Dow Theory was an attempt by Charles H. Dow to measure this movement by means of the average price of a selected number of stocks and to use these averages to predict the behavior of business trends. Mr. Dow founded the Dow-Jones Financial Service.

In a number of editorials in the Wall Street Journal, he outlined the basic principles of what is now known as the Dow Theory. However it was left to William P. Hamilton, his successor at the Journal to organize the Dow Theory and formulate it in the form it is known today. The goal of the theory is to determine changes in the primary movement of the market. Once a trend has benn established, it is assumed to exist until a reversal is proved. Dow theory is concerned with the direction of a trend abd has no forecasting value as to its ultimate duration size.

** Interpreting the theory **

1. The average discount everything

Change in the daily closing prices reflect the agregate judgement and emotion of all stock market participant. It is of course impossible to predict random natural disasters (Acts of God), but even in this case it is thought that once the event has occurred, the market is capable of assessing and discounting its impact.

2. The Market moves with Three types of movement.

The Primary movements are the broad over-all movement of the market and lasts for a period of more than a year. The Primary Movement is actually made up of a number of Intermediate up and down movements the effect of which is to keep the market moving in the direction of the Primary trend.

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 eveolves as the level of business activity and profits decline. The bear market reach a climax when stocks are liquidated regardless of their underlying value (because of depressing state of the news or because of forced liquidation caused), 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 know 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.

The Secondary Reaction moves opposite to the primary trend. It generally lasts between three weeks and three months and typically retrace about a third to a half of the last intermediate move

Minor movements lasts froma 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.

3. Lines Indicate Movement

An advance above the limits of the line indicates accumulation and predicts higher prices and vice versa. When a line occurs in the middle of a primary advance, it is really forming a orizontal secondary movement and should be treated as such.

4. Price or volume relationship provide background

If volume becomes dull on a price advance and expands on a decline, a warning is given that prevailing trend may soon reversed.

5. Price Action Determines the Trend

Bullish indication are given when succesive rallies penetrate peaks while the through of an intervening decline is above the preceding trough.

6. The Average 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. The need for confirming action by botth average would seem fundamental logical , because if the market is trully 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 expanding economy.