An Update on Classical Dow Theory
By Tim W Wood CPA, September 19, 2008
In light of the price action this past week I have had a number of articles on Dow theory brought to my attention. Some of these articles have suggested that the Dow theory is bullish while others suggest it is bearish. Other articles that have come to my attention say that because of the fact that the Transports have not confirmed the downside movement seen by the Industrials, that this is a sign of strength.
When I read some of these so-called “Dow theory” articles, it becomes obvious to me that the majority of the authors have not studied the original writings of our Dow theory founding fathers, who were Charles H. Dow, William Peter Hamilton and Robert Rhea. When reading these writings it is clear that the one single most important aspect of Dow theory is the price movement above and below previous secondary high and low points. Also, if there was a single most important lesson learned from the 2002 to 2007 advance, it was again, that the single most important aspect of Dow theory is the price movement above and below previous secondary high and low points. I know, because I gave more weight to other factors, and as a result I initially failed to accept the fact that in June 2003 when both averages moved above their previous secondary high points that the next leg up in the bull market had begun. This is a lesson that I learned the hard way, and when I look back upon the original writings by the Dow theory founding fathers, it was very, very clear. So, as I read these articles it is obvious from my seat that either the author has not read the original writings on this topic or for some reason has not yet learned their lesson as to proper interpretation of Dow’s theory. Please understand that I write this not so much as criticism, but rather in an attempt to clarify what I believe the “stock market barometer” is saying as well as what I believe are misinterpretations of classical Dow theory.
Let’s first begin with a chart and how we got to this point. In October 2007 we saw a non-confirmation surrounding that top. I want to also point out that this top occurred in conjunction with other important stock indexes including the Chinese stock market. Anyway, it was from the October 2007 Dow theory non-confirmation that the first indication of trouble began. This was soon followed by the decline in November that carried price below their August 2007 secondary low points. In doing so, I said then that in accordance with classical Dow theory, the primary trend had turned bearish. It was also at this point that as William Peter Hamilton once described, the “stock market barometer” was looking ahead and forecasting stormy financial conditions. I would think that this is now obvious to all. There is no doubt that Dow theory clearly warned of the financial woes we are now seeing way back in October and November of last year.
The next relevant Dow theory point is that once a primary trend change occurs, that newly established trend must be considered to be in force until it is reversed. Here is a quote from Robert Rhea in regard to this topic. In this case he is talking about a bullish trend, but the principle in bear markets is exactly the same only in reverse, and Rhea made this point very clear in his writing as well.
“Under Dow’s theory the primary trend, once authoritatively established as bullish, is considered to be continuing in force until negated by a confirmed bearish indication such as would be the case when, after a reaction of full secondary proportions in a bull market, a rally fails to lift both averages to new high ground, and a later decline carries both averages below the preceding secondary low.”
If we change the wording of this quote to fit a bear market scenario, it would read as follows. Under Dow’s theory the primary trend, once authoritatively established as bearish, is considered to be continuing in force until negated by a confirmed bullish indication such as would be the case when, after a reaction of full secondary proportions in a bear market, a decline fails to carry both averages to new low ground, and a later advance carries both averages above the preceding secondary high.
Well, if you look at the chart above it is clear that both averages moved to new low ground in January, which was the last “in gear” point. From there the Industrials moved lower into their March secondary low point while the Transport’s secondary low point from January held. This in turn created a Dow theory downside non-confirmation. It was then from these secondary low points that price advanced into their May/June secondary highs, which created an upside Dow theory non-confirmation, as is noted in red. It was then from these highs that the averages moved down into their joint July secondary low points. But in the case of the Industrials, this was a lower low, which created another downside non-confirmation as is noted in green. More recently, this past week in fact, the Industrials have violated their July secondary low points while the Transports are thus far still holding above theirs. So, this downside non-confirmation still exists and nothing has occurred to invalidate the previously established primary bearish trend change from November 21, 2007. It is this downside non-confirmation that some are quoting as being bullish. This is simply not true. Non-confirmations are warnings of a possible trend change. But, bullish? I don’t think so! In fact, here is what William Peter Hamilton and Robert Rhea had to say about Dow theory non-confirmations:
William Peter Hamilton – “The movement of both the railroad (now the Transports) 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.”
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 – “The Dow theory deals exclusively with the movement of the railroad and industrial stock averages, and any other method would not be Dow’s theory as expounded by Hamilton.”
Robert Rhea – “A wise man lets the market alone when the averages disagree.”
Robert Rhea – “When the averages disagree they are shouting ‘be careful’.”
So, if we take the writings and orthodox Dow theory methods explained by Hamilton and Rhea a couple of points are very, very clear.
One, these non-confirmations are not necessarily bullish. Non-confirmations are no doubt warnings of a possible trend change. Nothing more, nothing less. A non-confirmation may turn out to be bullish, bearish or it may even be a temperature even. Again, they are warnings and as Rhea stated above: “A wise man lets the market alone when the averages disagree.”
Two, the previously established bearish trend chance that I have been warning about since November 21, 2007 still remains intact as nothing has occurred to reverse it.
Three, the “Stock Market Barometer” has in fact done an excellent job of forecasting the stormy conditions that have occurred since the November primary bearish trend change first occurred.
Four, the joint price movement surrounding previous secondary high and low points is key.
Tim W. Wood
© 2008 Tim Wood