Psychology of the Crowd vs. Dow Theory and Technical Analysis

By Tim W Wood CPA, April 2, 2004

In July 2001 I wrote an article that was later published in the November issue of Technical Analysis of Stocks and Commodities Magazine. In this article I forecasted that the Dow Jones Industrial Average would move below 7,400 in late 2002. At the time of this analysis the DJIA was at approximately 10,500. It was November 2002 before the article could make it through the pipeline and into print. By September 2001, the market had dropped to near 8,000. By the time the analysis appeared in November, the DJIA had recovered and was well over 9,000. People were arguing that the worst was over. We had seen the bottom. The article was discounted by many. After all, common knowledge was that the bottom had been seen. Sound analysis that was based in fact and statistical probability was useless bunk. In October 2002 this forecast came to be. As it turned out, the analysis was proven to be right and the collective wisdom of the masses once again was proven to be in error.

In the spring 2002 issue of Traders World Magazine, I forecasted that the CRB Index would find its 3-year cycle low in early 2002. I also forecasted that the Dollar was topping and that when the intermediate term cycle that was then at play topped we would have the 4-year cycle top in the Dollar. With commodity prices as depressed as they were at the time and the Dollar as high as it was, this forecast too was discounted by many. The popular delusion of the day seemed to call for a strong Dollar and weaker commodities. However, sound analysis once again won out as we all now know what has happened since that time.

Now, I want to turn to E. George Schaefer's book, How I Helped More Than 10,000 Investors to Profit in Stocks. Mr. Schaefer estimated that he spent some $300,000 to $400,000 over an eight year period in an attempt to reach the public about the young Bull Market that was then underway. In 1952 one of Schaefer's articles was entitled "The Coming Boom." In 1953 he wrote another called "The Boom Begins." In 1954 he wrote "The Boom Expands" and in 1955 he wrote, "Higher Prices Coming." Below is a chart showing the DJIA during this time and the years that followed. In these ads, while the DJIA was still in the 300, 400 and 500 levels, Mr. Schaefer states that he often repeated the reasons why a much higher market was expected, and used ideas and thoughts related to past experiences and to his bullish Dow theory and technical studies to help the reader to establish his bullish thinking in regards to the fabulous long-term Bull Market that was underway.

Mr. Schaefer went on to state, "Of course, since many other analysts were advertising bearishly, the competition was almost overwhelming, and only a relatively small percentage of all who read my ads, my advertising in the mails, and my weekly letter, were thoroughly convinced that a major Bull Market was with us all the way up. Out of an estimated 500,000 readers, I have approximated that 25,000 received some benefit, and that's only 5%. And, out of today's 12,500,000 investors, it is only to 1%."

In 1954 Mr. Schaefer receives the following letter from one of his subscribers, "Schaefer, you seem to be blind to the great dangers of this market. I suggest that you take time to read what other writers are saying. You are what I call a "perpetual bull." I am afraid of a bear market and big losses ahead, and for that reason, I can’tgo along with your reasoning. As I see it, lower prices are coming."

I have to say that from my perspective nothing has changed. It's only the direction of the market that people are now afraid of. The masses are afraid of missing the next move up and anyone that sounds the warnings based on Dow theory and other technical studies are "Perma Bears."

Mr. Schaefer quotes French sociologist, Gustave Le Bon who once said, "The masses live by, and are ruled by, subconscious and emotional thought process. The crowd has never thirsted for the truth. It turns aside from evidence that is not to its taste, preferring to glorify and to follow error, if the way of error appears attractive enough, and seduces them. Whoever can supply the crowd with attractive emotional illusions may easily become their master; and whoever attempts to destroy such firmly entrenched illusions of the crowd is almost sure to be rejected."

There are more examples. On October 21, 1929 (this was 3 days before the panic began) the following appeared in The Wall Street Journal by William Peter Hamilton. "If, however, the market broke again, after a failure to pass the old highs of September 3, 1929 at 381.17, and the decline carried the price of the Industrials below 325.17 and the Railroads below 168.26, the bearish indication would be strong, and might well represent something more than a secondary reaction." Below is a chart for reference.

Rhea wrote, "The critical points mentioned above were broken on October 23, 1929, and the next day William Peter Hamilton wrote his famous editorial in The Wall Street Journal, which appeared on the morning of October 25,1929 under the caption, A TURN IN THE TIDE, which is quoted in full as follows:"

"On the late Charles H. Dow's well known method of reading the stock market movement from the Dow-Jones averages, the twenty railroad stocks on Wednesday, October 23 confirmed a bearish indication given by the industrials two days before. Together the averages gave the signal for a bear market in stocks after a major bull market with the unprecedented duration of almost six years. It is noteworthy that Barron's and the Dow-Jones NEWS service on October 21 pointed out the significance of the industrial signal, given subsequent confirmation by the railroad average. The comment was as follows:

"If, however, the market broke again, after a failure to pass the old highs, and the decline carried the price of the industrials below 325.17 and the railroads below 168.26, the bearish indication would be strong, and might well represent something more than a secondary reaction, however severe. It has often been said in these studies of the price movement that the barometer never indicates duration. There was a genuine major bear market in 1923, but it lasted only eight months. One good reason for not taking the present indications too seriously is that they have all been recorded in a most unusually short space of time. The severest reaction from the high point of the year had just one month's duration. In view of the nation-wide character of the speculation, this seems a dangerously sort period to infer anything like complete reversal in public sentiment."

There was a striking consistency about the market movement since the high figure of September 3. There were at least four rallies in the course of the decline in the industrials before the definite new low point was established and each of these was weaker than the last. Dow always considered this a danger signal, but for the past thirty years it has been the custom in discussing the stock market as a barometer of business to require that one average should confirm the other. Failure to agree has been found deceptive.

There are people trading in Wall Street, and many all over the country who have never seen a real bear market, as for instance, that which began in October 1919, and lasted for two years, or that from 1912 to 1914 which predicted the Great War if the world had then been able to interpret the signs. What is more material is that the stock market does forecast the general business of the country. The big bull market was confirmed by six years of prosperity and if the stock market takes the other direction there will be contraction in business later, although on present indications only in moderate volume.

Some time ago it was said in a Wall Street Journal editorial that if the stock market was compelled to deflate, as politicians seemed so earnestly to wish, they would shortly after experience a deflation elsewhere which would be much less to their liking."

Of course few listened to Hamilton's warning, as the politicians of the day explained that all was well. Right after the collapse in stock prices President Hoover reassured the population that the crash reflected only a financial crisis but that the industries (their manufacturing facilities and distribution channels) were basically sound. Henry Ford declared, on November 4 of 1929 that "Things are better today than they were yesterday" Hoover said a week later that "any lack of confidence in the economic future of American enterprises is foolish." Charles Schwabb, president of Bethlehem Steel said in December of 1929 that "never before have American finances been so soundly prepared for prosperity than now." But sooner than later reality proved the President and all the business leaders wrong and they had to accept that the economy was in a profound recession and later a depression of unimaginable consequences.

Robert Rhea wrote the following about the rally that ran from November 1929 to April 1930. See the chart below for reference. "Nearly everyone was proclaiming a new bull market. Services were extremely bullish, and the upside volume was running higher than at the peak in 1929." This rally recovered just over 50% and in spite of public opinion it still proved to separate Phase I from Phase II of the great Bear Market. Again, Dow theory was right and the wisdom of the masses was wrong.

Robert Rhea Calls the End of the Great 1929 to 1932 Bear Market using Dow's theory. He turns bullish on July 21, 1932.

Robert Rhea warned extensively in his newsletters between November 12, 1932 and May 10, 1933 that the bear market was ending. Few listened. The following are excerpts from some of his newsletters.

November 22,1932

"In mailing No. 1, I explained why, under a strict interpretation of Dow's theory, we must call this a bear market. Both bull and bear arguments on the subject were summarized. Personal convictions were not injected into the discussion , but several subscribers have insisted that it be done. I believe July 8, 1932 was the end of the great bear market. On July 21 when the Industrials closed at 46.50 and the Rails at 16.76, I asked my broker to tell my friends trading in his various offices that I thought the Dow theory implied heavy buying for the first time in over three years. On July 25, 1932, the opinion below was sent to perhaps fifty correspondents.

The declines of both Rail and Industrial averages between early March and midsummer were without precedent. The thirty-five year record of the averages shows a fairly uniform recovery after every major primary action, and such recoveries average around 50% of the ground lost on the decline; are seldom less than a third and more than two thirds. Such recovery periods tend to run to about 40 days, but are sometimes only three weeks - and occasionally three months.

The time element is in favor of a normal reaction at this time - because the slide off was normal (the normal time interval of major declines being about 100 days).

The market gave the unusual picture of hovering near the lows for more than seven weeks, and might be said to have made a "line" during the latter weeks of that period.

Because of all these things, and because the volume tended to diminish on recessions and increase on rallies during the ten days preceding July 21, almost any one trading on the Dow theory would have bought stocks on July 19th. Those who did not, had a clean cut signal again on the 21st. Since that date the implications of the averages have been uniformly bullish, and it is reasonable to expect that a normal secondary will be completed, even though the primary trend may not have changed to "bull". So much for the speculative viewpoint.

However, the investor asks, "Have we seen the lows for the bear market?" According to strict construction of Dow theory, we cannot yet tell.

Surely we have many things which might lead us to believe this to be true - we have surely had a considerable period of accumulation, but these periods frequently preface secondary reactions, or occur at some intermediate point in a secondary. Should this secondary reach normal limits with respect to recovery and duration, and a decline of some weeks follow, and this decline did not break the bear market lows, after which a recovery set in which carried above the high point of the secondary now in the making, it would seem reasonable to suppose that the lows had been passed. And should the secondary now forming develop a sideways drag, beneath normal expected recovery points, making a clearly defined "line", and should such a line be broken topside with some healthy advances, it would be a splendid buying signal."

February 8, 1933

"While we wait for the verdict, it is well to remember that, under Dow's theory, the last clear primary signal was bearish, and that we need the penetration of (P) topside for a secondary rally signal, and of (D) to give a complete bull signal."

The secondary reaction that Rhea spoke of above in his November 12, 1932 newsletter occurred between September 1932 and February 1933. Notice that the low point of the reaction held above the bear market low point. The rally that followed carried the Industrials above the September 1932 high point on May 10, 1933. On May 24, 1933 the Transports followed and the Primary Trend turned Bullish. Also notice that Rhea did not wait for confirmation of the Primary Trend before he began buying.

May 10, 1933

"The bull point (D) for Industrials was the September high of 79.93. Today's close of 80.78 (preliminary), having exceeded that of (D), means that the Industrials have at least done their half of the bull signal job. All that is now needed is for the Rails to confirm the action of their companion average. The Rails today exceeded last week's high point by a liberal margin, and this performance considered in conjunction with the premier performance of Industrials gives us reasonably certain assurance that the mild minor reaction of last Saturday and Monday has ended. One more day's advance for both averages would justify the assumption that the steam pressure in the market boiler is increasing, and that power will soon be generated sufficient to lift the Rails through their bull point of 39.27. Added authority for bullish hopes would be a broadening of activity as further advances occur.

The implied advance certainly warrants speculative attention, because penetration of primary points is most generally followed by a further upsurge.

Ordinarily an investor who did not load up near the July lows (as he probably would have done had he followed Dow's theory) would buy his long pull line whenever (D) had been penetrated topside by both averages. This will be good practice now if a market correction occurs before (D) is penetrated by the Rails; however, should the Rails confirm the Industrials' action before some drastic reaction occurs (and no reaction seems probable for nearby movement), then it is reasonable to suppose that when the eventual reaction does develop, retracing from 1/3 to 2/3 of the advance since (S), prices will in all probability decline below those of today.

It should be noted here that points of primary importance are seldom penetrated by both averages on the same day. Several days, weeks, or even months have elapsed before joint confirmation, as a study of averages will reveal.

The averages on present reading continue to indicate, as they have done for several weeks past, that the line of least resistance remains upward."

May 17,1933

The Bullish Primary Trend is Confirmed

"Recent hesitation augurs well for an early penetration of its bull point by the Rail average, and, if precedent holds true, a substantial further advance, without material reaction, should follow that event.

This is a rather prosaic letter to celebrate the approach of an event, which we have waited for since �29. I have written about this point (D) for so many months, and past letters have discussed its significance in such detail, that nothing more remains to be said."

BUT, Few Listen to Rhea

"Through the long drag from October '32 to the middle of last April, the averages have consoled those long of stocks, because accumulation was indicated. It is certain that the price movement gave tangible and timely warning of the splendid advances since mid-April. Nothing since then has indicated weakness. For weeks these letters have given bullish interpretations to the price movement; nevertheless, criticisms have been made because discussions are perhaps 95% retrospective and 5% introspective. Without meaning to go on the defensive, I respectfully suggest that Dow's theory is best learned through repeated reviewing of both ancient and current movements. The primary objective of these letters is to encourage readers to learn to recognize the voice of the averages; to become their own oracles, and to learn to ignore the unorthodox and misleading explanations of Dow's theory written by men, either too lazy, or who lack the mentality, to master a simple subject."

If we fast forward to the present, I find the situation much the same. I have been pounding the table ever since the rally out of the March 2003 low began, that it was a bear market rally. I wrote an article which appeared in the October 2002 issue of Technical Analysis of Stocks and Commodities Magazine showing what to expect once the 4-year cycle low appeared. I explain that most would proclaim it to be a new bull market. I gave statistical relationships of previous bull and bear markets and showed what our expectation for this bear market should be. In my newsletter and articles I have used ideas and thoughts related to history, Dow theory and other technical studies to help the reader to understand the current conditions of the market. Just as Schaefer was called a "Perpetual Bull," I have found myself and the few others that have warned of current market conditions called "Perma Bears" and even worse.

Tim W. Wood

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Tim W. Wood CPA
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