Basic Market Theory And Its Application

Includes: DIA, IWM, QQQ, SPY
by: Brian Sanders


The three following theories are relatively simple in words but interesting in practice.

Given financial markets are so in-depth, people have developed market theory to understand underlying occurrences throughout the years.

These studies have brought both traders and investors notations of strategic thinking and objectiveness.

Financial economics is defined as: "A branch of economics that analyzes the use and distribution of resources in markets in which decisions are made under uncertainty...employs economic theory to evaluate how time, risk (uncertainty), opportunity costs and information can create incentives or disincentives for a particular decision." - Investopedia

Understanding how markets work requires a serious amount of time and effort, whether it's trying to understand the day to day movements or developing a sense of a long term outlook for an entity (whether it's a country, business, and so on). While I tend not to follow market theories religiously, as I am a value investor, I do find them to be pretty interesting and have found that they do pan out in reality.

Sidenote: This is an article for new investors.

Dogs of the Dow Theory

An under followed but relatively well known strategy is this one. The premise behind this portfolio strategy is to not only potentially outperform the market but also protect one's capital by investing in top notch businesses. Investors employ this strategy by selecting the 10 highest dividend yielding stocks and allocate their capital into them accordingly. Studies have found that this is a great way to passively invest in the market, versus a traditional index or mutual fund. For example, if the Spyder DJIA (NYSEARCA:DIA) generated an outstanding 15% annualized return for a given year, this would be pushed to an estimated 20%. Throughout the year investors are also advised to readjust their portfolios to maintain the simple criteria. As of right now, the top 10 offer a maximum to minimum yield of 5.4 to 3.18% respectively. Inclusive of capital appreciation, investors should slightly surpass beta benchmarks.

Dow Theory

Although primarily viewed as a form of technical analysis, it actually heavily involves capital inflow and outflow (cash rotation) and why markets move the way they do. It is heavily involved with trends. Stated below are the 6 basic principles:

  1. Markets have three movements. The long, intermediate, and short term where each can be independently bullish or bearish.
  2. Markets have three phases. Accumulation, momentum (public eye), and distribution. This is very similar to the economic cycle.
  3. Markets account for all news. As soon as information is released, market participants react accordingly.
  4. Indexes confirm each other, in general. This is seen on a day to day basis. If the DJIA rips higher by 100 points, the NASDAQ will likely not be falling.
  5. Trends are confirmed by volume. It's interesting to see how people debate this topic, as some people are actually attracted to higher volume, when in reality it usually spells trouble. Obviously candlesticks, red or green, will dictate the price movement, but heavier volume is something to be noted.
  6. Trends will remain until confirmed otherwise.

Technical analysts continue to use these sub-categories every day to see where the big money is going. Whether it's stocks, bonds, precious metals, or what have you. In the end, the trend is your friend.

Elliot Wave Theory

EWT is basically the study of market price action, a form of technical analysis. What is states is that typically there is a trend that persists, either bullish or bearish, but during this time there are continuously blips of contrarian price action. In other words, even though the stock market could have a 10 year bull run, doesn't mean that there will not be head-fakes (and big ones too). This is the theory illustrated:

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Generally this holds true for all different financial markets, and more so in particular areas, like gold and currencies. Traders also heavily employ this basic strategy with more complicated tools like screenings, correlations, volatility, geometric analysis, etc. What is interesting however is that sometimes this notion is thrown completely out the window and traders need to understand that.

Final Thoughts

These are three relatively simple theories that I think everyone handling their own money should know. While financial markets may not be easy to understand, people should realize that it isn't just a one way street or a rollercoaster. To that end, there is a method to the perceived madness. Hope this helped some of you readers out there.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.