The Dow Report: Questions on Dow Theory

By Tim W Wood CPA, November 11, 2005

Recently, I have received a number of questions on Dow theory. The two commonly asked questions are about the recent new highs made by the Transports and manipulation. As for the recent new highs on the Transports, this has not produced a "buy" signal. The fact that the Transports have now pushed to new highs, that have not been confirmed by the Industrials, is a warning, not a buy signal.

Below are a few quotes from the great Dow theorist of the past on this subject:

Robert Rhea - "The most useful part of the Dow theory, and the part that must never be forgotten for even a day, is the fact that no price movement is worthy of consideration unless the movement is confirmed by both averages."

Robert Rhea - "A wise man lets the market alone when the averages disagree."

Robert Rhea - "When the averages disagree they are shouting ‘be careful.’"

William Peter Hamilton - "The movement of both the railroad and industrial stock averages should always be considered together. The movement of one price average must be confirmed by the other before reliable inferences may be drawn. Conclusions based upon the movement of one average, unconfirmed by the other, are almost certain to prove misleading."

William Peter Hamilton - "Dow's theory stipulates for a confirmation of one average by the other. This constantly occurs at the inception of a primary movement, but is anything but consistently present when the market turns for a secondary swing."

William Peter Hamilton - "When one breaks through an old low level without the other, or when one establishes a new high for the short swing, unsupported, the inference is almost invariably deceptive."

William Peter Hamilton - "Indeed it may be said that a new high or a new low by one of the averages unconfirmed by the other has been invariably deceptive. New high or low points for both have preceded every major movement since the averages were established."

William Peter Hamilton - "The two averages may vary in strength, but they will not vary materially in direction especially in a major movement. Throughout all the years in which both averages have been kept, this rule has proved entirely dependable. It is not only true in the major swings of the market, but it is approximately true of the secondary actions and rallies. It would not be true of the daily fluctuations, and it might be utterly misleading so far as individual stocks are concerned."

I have found that even though these words were written over 70 years ago, they remain as true today as they did then. I know that there are many who are critical of the Dow theory and proclaim that it is no longer valid for one reason or another and that this time is different. The historical writings on Dow theory also tell us that people have made these same arguments over and over again. Yet, the Dow theory has held true. The alleged problem with Dow theory has nothing to do with Dow theory at all. It has to do with human emotion. The Dow theory often looks further over the horizon than we know, and when its warnings do not culminate as quickly as one believes they should, then they begin to make the argument that this time is different and that the Dow theory is no longer applicable. This cycle of discounting the Dow theory and then seeing it proven correct has occurred over and over again. It's only human nature.

In the interim, yes, the "Secondary Trend" is currently bullish. But, this non-confirmation is a serious warning that the Secondary Trend is in jeopardy. Also, think about this; the Primary Trend remains bearish and the Primary sell signal according to Dow theory still stands today. If the Dow theory was not relevant, then why is it that this giant bear market rally separating Phase I from Phase II of the bear market has not been able to carry the Industrials to new highs? Guys, we are still at the same levels on the DJIA as we were in 1999. That was 6 years ago. If this were a "new bull" market don't you think we should have made a new high by now? I maintain that the advance out of the 2002 low was merely a Secondary Reaction separating Phase I from Phase II of the ongoing bear market. Furthermore, the sideways action that has been seen since January 2004 is part of the topping process associated with this giant bear market rally.

Now for the question of manipulation. Many argue that manipulation will skew the outcome for Dow theory or any other technical approach. This is not true. Dow theory and technical analysis is concerned with price movement. It does not matter what the underlying reason is for that price movement. After all, everything is reflected in price and since the technical approach deals with price, the reason for the price movement is not a factor because price has discounted the reason. Now, this is not to say that I do not believe in manipulative efforts to "hold the market up." But from a technical perspective, any such efforts simply prolong the inevitable. No amount of manipulation on the planet can change the fact that the rally out of the October 2002 lows were only the Phase I lows, and no amount of manipulation can prevent the inevitable Phase II and ultimately the Phase III low from occurring. All that can be achieved by any such efforts is to prolong these inevitable declines. Again, look at the many efforts that have occurred over just the last two years to "keep the market up." Yet, the Industrials are sitting right where they were in January 2004. All this has done is prolong the inevitable, and by doing so it has lulled the masses into actually believing that we are in a new bull market.

Below are a few words by Robert Rhea and William Peter Hamilton on Manipulation:

"Manipulation is possible in the day to day movement of the averages, and secondary reactions are subject to such an influence to a more limited degree, but, the primary trend can never be manipulated.

Hamilton frequently discussed the subject of stock market manipulation. There are many who will disagree with his belief that manipulation is a negligible factor in primary movements, but it should always be remembered that he had, as a background for his opinions, a most intimate acquaintance with the veterans of Wall Street, and the advantage of having spent his life in accumulating facts pertaining to financial matters.

The following comment, taken at random from his many editorials, affords convincing proof that his views on the subject of manipulation did not vary:

"A limited number of stocks may be manipulated at one time, and may give an entirely false view of the situation. It is impossible, however, to manipulate the whole list so that the average price of 20 active stocks will show changes sufficiently important to draw market deductions from them." (Nov. 29, 1908)

"Anybody will admit that while manipulation is possible in the day-to-day market movement, and the short swing is subject to such an influence in a more limited degree, the great market movement must be beyond the manipulation of the combined financial interests of the world." (Feb.26, 1909)

"the market itself is bigger than all the "pools" and "insiders" put together." (May 8, 1922)

"One of the greatest of misconceptions, that which has militated most against the usefulness of the stock market barometer, is the belief that manipulation can falsify stock market movements otherwise authoritative and instructive. The writer claims no more authority than may come from twenty-two years of stark intimacy with Wall Street, preceded by practical acquaintance with the London Stock Exchange, the Paris Bourse and even that wildly speculative market in gold shares, "Between the Chains," in Johannesburg in 1895. But in all that experience, for what it may be worth, it is impossible to recall a single instance of a major market movement which depended for its impetus, or even for its genesis, upon manipulation. These discussions have been made in vain if they have failed to show that all the primary bull markets and every primary bear market have been vindicated, in the course of their development and before their close, by the facts of general business, however much over-speculations or over-liquidation may have tended to excess, as they always do, in the last stage of the primary swing." (The Stock Market Barometer) "no power, not the U. S. Treasury and the Federal Reserve System combined, could usefully manipulate forty active stocks or deflect their record to any but a negligible extent." (April 27, 1923)

"The average amateur trader believes the stock market is guided in its trends by a certain mysterious 'power,' this belief being the one factor, next to impatience, most responsible for his losses. He reads tipster sheets avidly; he scans the newspapers industriously for news likely, in his opinion, to change the trend of the market. He does not seem to realize that by the time the news of real importance is printed, its effect, so far as the basic trend of the market is concerned, has long ago been discounted."

"It is true that a flurry in the price of wheat or cotton may influence the day to day movement of stock prices. Moreover, sometimes newspaper headlines contain news which is construed as bullish or bearish by market dabblers, who collectively rush in to buy or sell, thus influencing or "manipulating" the market for a short period. The professional speculator is always ready to help the movement along by "placing his line" while the little fellow timidly "lays out" a few shares; then, when the little fellow decides to increase his commitments, the professional begins to unload and the reaction ends, and the primary movement is again resumed. It is doubtful if many of these reactions would ever be caused by newspaper headlines alone unless the market was either overbought or oversold at the time---the "technical situation" so dear to the hearts of financial news reporters."

"Those who believe the primary trend can be manipulated could, no doubt, study the subject for a few days and be convinced that such a thing is impossible. For instance, on September 1, 1929, the total market value of all stocks listed on the New York Stock Exchange was reported to have amounted to more than $89,000,000,000. Imagine the money which would have been involved in depressing such a mass of values even 10 per cent!"

If you would like more details on the day to day development, the identification of the shorter-term cycle tops and bottoms, long and intermediate-term time and price projections, then Cycles News & Views may be what you are looking for. For more details please visit www.cyclesman.com.

Tim W. Wood

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