Dow Theory: Why Opinions Differ and Brief Update
By Tim W Wood CPA, November 28, 2008
It’s amazing how many people write articles and publish material on Dow theory. The sad thing is that the vast majority of the material I see is dead wrong. Recently, I was sent an older article that was published by a Certified Financial Analyst stating that a Dow theory “buy signal” was triggered on April 18, 2008. I was asked why that so-called signal failed and why my read on the Dow theory has proven correct. It’s simple. When I read these articles I always see a common denominator in that it becomes immediately apparent that the author had never actually studied the original writings of Charles H. Dow, William Peter Hamilton or Robert Rhea. If you are not aware of the Dow theory lineage, you can read more about this here.
Anyway, I have found that Robert Rhea’s material is essential if one is truly going to understand what has come to be known as Dow theory. The bottom line is that it is simply impossible for one to speak on a subject in which they do not have a sufficient depth of knowledge without getting the facts wrong. The only other person I know who has also studied the original writings by Charles H. Dow, William Peter Hamilton and Robert Rhea is Richard Russell. As a result, Mr. Russell is the only other orthodox Dow theorist that I know of and he told me that he has fought misquotes, misunderstandings and erroneously written articles his entire career.
I first warned about the Dow theory non-confirmation in October 2007. I then lead my subscribers through the technical maze as we watched the primary bearish trend take root. According to classical Dow theory, the primary bearish trend change finally occurred on November 21, 2007. It was at that time that the “stock market barometer,” according to William Peter Hamilton, first forecasted “stormy economic conditions.” Then, as the markets rallied out of the January secondary low points and into the May 2008 and even the August 2008 highs I explained that nothing had occurred to invalidate the establishment of the November 21, 2007 primary bearish trend confirmation. Yes, this is all in print and even to date nothing in accordance with classical Dow theory has occurred to change the establishment of the primary bear market that was first confirmed on November 21, 2007. The most important aspect of Dow theory is the joint movement of the Industrials and the Transports above and below previous secondary high and low points. As you can see on the chart below, the averages last made a joint price low on November 20, 2008, which served to yet again reconfirm the bearish primary trend that was established on November 21, 2007. Now, this is not to say that there won’t be bounces. Of course there will and following every secondary low point there is of course, a bounce into a secondary high point. The key is understanding when a secondary low point has been made, what the advance into the secondary high point is telling you and then identifying the turn down out of that secondary high point.
Now the question on many peoples’ mind is, how long does this bear market last? Well, Dow theory doesn’t directly offer an answer to this question, but there are some inferences that can be drawn upon. First, it is important to understand that the definition of Bull and Bear market differs from person to person. My definition is based on the works of the great Dow theorists, Charles H. Dow, William Peter Hamilton and Robert Rhea. As a result of my study of Dow theory combined with my study of cycles, which are not a part of Dow theory, I have drawn some very obvious conclusions about the nature of Bull and Bear markets.
As I read about the bull and bear markets of the late 1800’s and very early 1900’s, it becomes apparent that the bull markets Dow, Hamilton and Rhea wrote about were the upward movements of the 4-year cycle and the bear markets were the downward movements of the 4-year cycle. As our country grew, more and more people began investing and as a result the bull and bear periods became longer and evolved into a series of multiple 4-year cycle periods. For example, the first bull market to consist of multiple 4-year cycles ran from 1921 to 1929 and consisted of two 4-year cycles. The low in November 1929 was a 4-year cycle low. The rally, or “Secondary Reaction,” that followed was the upside of a 4-year cycle that topped in only 5 months. Once this “Secondary Reaction” was over, the DJIA moved down below the previous 4-year cycle low and into the 1932 4-year cycle low, which proved to be the bear market bottom. I would also like to point out that the 1921 to 1929 bull market advanced a total of 568% from the 1921 4-year cycle low at 67 on the DJIA to the 1929 4-year cycle top at a high of 381 on the DJIA.
The next great bull market began with the 4-year cycle low in 1942 and ran to the 4-year cycle top in 1966. This time the “Primary” bull market was comprised of a series of six 4-year cycles and advanced a total of 1,076% from the 1942 4-year cycle low at 93 on the DJIA to the 1966 4-year cycle top at a high of 1,001 on the DJIA. Note that this bull market advance was roughly double the preceding great bull market. The bear market that followed was also a series of 4-year cycles. From the 1966 4-year cycle top, the bear market moved down into the 1974 bear market low. This was a series of two 4-year cycles.
Now, I want to focus on the bear market declines. Prior to the first great bull market that ran between 1921 and 1929, the bear markets averaged some one-third the duration of the previous bull market. This relationship has also held true with the extended bull market periods as well. For example, the 1921 to 1929 bull market was 8 years in duration and the 1929 to 1932 bear market was 3 years, making the bear market duration 37.5% of the preceding bull market. The 1942 to 1966 bull market was 24 years in duration and the 1966 to 1974 bear market was 8 years, which was 33.3% of the duration of the preceding bull market.
From a cyclical perspective, the last and greatest bull market of all time began with the 1974 4-year cycle low. Some say that it began at the 1982 low and I understand that argument. However, from a cyclical perspective the bull market began in 1974 and this was the actual low point of the 1966 to 1974 bear market. The year 1982 was when the bull market broke out and became apparent.
At the 2000 top, the associated Dow theory non-confirmation and confirmed primary trend change indicated at the time that this great bull market era had ended. Upon the primary trend confirmation in March 2000, all indications, according to Dow theory phasing, was that Phase I of a great bear market had begun. Also, based upon the historical relationships between bull and bear markets, that bear market was slated to run into the 2008 to 2010 timeframe, which was 33 to 37% of the preceding bull market. Again, when the rally out of the 2002 low began it appeared that this was simply the rally separating Phase I from Phase II of the bear market.
However, the powers that be threw everything they had at the market and in doing so they allowed the bear to claw its way out of existence, and when both averages managed to better their 2000 highs, everything changed in accordance with Dow theory phasing. I said at that time “I can tell you that this confirmation does not signal a “new” bull market, but rather reconfirms the existing bull market.” What I was saying here in early 2007 was that the bull market that began in 1974 was reconfirmed as still being intact when both averages jointly bettered their 2000 highs and that we had never entered into a true bear market. This was written in an article on February 29, 2007.
Anyway, the advance that followed this reconfirmation carried the averages up into their last joint high, which occurred in July 2007, and can be seen in the Dow theory chart above. From the July 2007 joint high the averages moved down into their August 2007 secondary low points. It was then from that secondary low point that things began to once again deteriorate. As you can see in the chart above, the Industrials moved on to new highs in October while the Transports failed to confirm. This non-confirmation is noted in blue.
It was this non-confirmation that lead to the November 2007 decline and with the break below the August 2007 secondary low points, noted in green, on November 21, 2007 the Primary trend was once again confirmed as being bearish. That break put the market at risk of finally marking the top of the entire bull market advance that began in 1974 at 570 on the Industrials. As of the October 2007 high the bull market advance that began in 1974 has now run 33 years and has consisted of eight 4-year cycles with a total advance of 2,385%. Note that this advance has been roughly double the previous bull market advance in terms of the percentage move out of the low in which the bull market began.
Now the question at hand is, did the October 2007 top mark THE top of this entire bull market advance up from the 1974 low? If so, then we are now operating within the context of a much longer-term secular bear market that should serve to correct the entire 1974 to 2007 bull market. Also, based upon the historical bull and bear market relationships of the past, the 33 year bull market period should be corrected by a 10 to 12 year bear market, which, based on the 2007 top, would take the bear market down into the 2017 to 2019 timeframe. Another point I want to make here is that back in 2000 the bull market from 1974 was only 26 years in duration and one-third of that would have been some 8 to 9 years, which means that if they would have let the bear market that tried to begin back then unfold, we would now be coming out of a natural bear market bottom in which a real advance could have occurred. Rather, they fought it tooth and nail and were ultimately able to extend the bull market into 2007. As I said all along, this only served to make matters worse. We now have a 33-year bear market to correct and we are only one year into it. Point being, if we have truly seen THE bull market top, then we still have some 9 plus years to go based on these typical bull/bear market relationships and fighting it will only extend the inevitable and make matters worse.
Tim W. Wood
© 2008 Tim Wood