The Dow Report: More Dow Theory Misconceptions
By Tim W Wood CPA, October 8, 2004
Recently, it seems that I am seeing more and more misquotes of Dow theory. It is apparent to me that these misquotes are a direct result of the lack of study on the subject. For that reason I have decided to again discuss a few of the more recent erroneous writings on Dow theory. I would like to address a few of these misquotes over the next few weeks because it serves as a great backdrop for teaching and correcting some of the current misconceptions of this great theory. Also, this is a good platform in which to do so.
A Dow Theory "Buy Signal" occurred in May 2003.
No such signal occurred in May 2003. Robert Rhea wrote, "a widespread opinion prevails among those who have not studied the subject that Dow's theory implies buying or selling after confirmation of primary direction of the market has been registered. If this were true, then there would be little use in our studying the theory."
In May 2003 the Transports moved above their previous secondary reaction high point. This created a non-confirmation that lasted until June 2003. Then, in June 2003 the Industrials also moved above their previous secondary high point. This in turn produced a SECONDARY Dow theory confirmation once both averages were back in gear above the previous secondary reaction high points. This is what is often referred to as a buy signal, but in reality, it serves as confirmation of the trend. So, just as Rhea explained above, many confuse these confirmations with buy and sell signals.
Another point to be made here is that the averages were not in gear in May 2003. But, the non-confirmation was corrected to the upside. So, in this case it turned out that the non-confirmation was corrected and the market moved higher. Rhea repeatedly warned that when the averages are not in gear they are shouting, "Be Careful!" Sometimes these non-confirmations are corrected and sometimes they are not. When the averages are not in gear, as is currently the case, we do have to wait until the previous secondary reaction high or low point is violated before we can draw any valid conclusions about the direction of the market. It can be seen in the writings of all of the great Dow theorists that the price action occurring between two secondary points offers NO forecasting value.
Recently, I have heard many making the argument that the Transports are a leading index. Therefore, many are drawing the conclusion that because the Transports are strong the Industrials are bound to follow.
From a traditional pure Dow theory perspective this is not so. Of all the Dow theory writings I cannot recall ever having seen such an inference by any of the great Dow theorists of the past. According to the original writing on Dow theory, the averages are either in gear and thereby confirming each other or they aren't. I too have studied the non-confirmations going back to 1896 and my conclusion is that one cannot draw any reliable conclusions based on such non-confirmations. My conclusions were the same as Rhea�s. When the averages are not in agreement one should simply "be careful."
Longer periods of non-confirmation imply weaker underling market conditions.
I can understand the logic behind such thought. But, this is not true and not supported by Dow theory. Let me explain. As an example, in 1956 both the Industrials and the Transports made joint highs. It was not until late 1963 when the Transports bettered the 1956 high. During this 7 year period the Industrials advanced some 46%. It is for this reason that under classic Dow theory we use the most recent secondary high and low points as our reference points for trend confirmation. I have seen major tops and bottoms occur with only the slightest Dow theory non-confirmation. One example of this was the 1987 top; 1987 was a 4-year cycle top and we all know what happened after that top. Yet, we only saw 7 days of non-confirmation at the top. The important thing with Dow theory is the violation of the previous primary or secondary high or low point.
I will cover more of these misconceptions in future market wraps. But for now, let's touch briefly on the current non-confirmation. This is truly a very serious issue and should not be taken lightly. The averages are not in gear and are screaming "Be Careful." Between March and September 2004 we saw a series of lower lows and lower highs in the Industrials and higher highs and higher lows in the Transports. Now, since the September highs, we are seeing another non-confirmation on a different scale. The Transports have now moved above their September highs, but the Industrials have failed. This has set up a double non-confirmation, if you will. This can be seen on the daily charts below.
Last week I stated that the current Dow theory implications for the market were bearish. I also stated that I was beginning to feel that the Industrials were going to move above their previous secondary high point and thereby give a confirmation of a secondary "buy signal." This feeling is now subsiding. The Dow theory implications remain bearish. The double non-confirmation is not good. The current state of the market is no doubt bearish and caution is advised. You have been warned, Again!
Tim W. Wood
© 2004 Tim Wood