The Dow Theory is the grandaddy of all technical analysis, and one of the most resilient in a profession that creates and discards indicators will nilly. In this article I will use the description and explanation of the Theory based on the book "Technical Analysis of Stock Trends," by Edwards and Magee. Like the theory, that book is a classic in technical analysis and should be on every investors shelf.
The purpose of the Dow Theory is to identify Bull Markets and Bear Markets so that long term investors (Dow Theory is no use to short term traders and irrelevant to that greatest of pestilences, day traders) can position themselves accordingly. Dow divided market fluctuations into three categories:
(1) The primary trend. This is just a more precise way of saying a Bull or Bear market. In recent decades there has been a lot of misunderstandings and sloppy use of the words Bull and Bear market, and for that reason I will introduce definitions which I will use throughout this article and others on SA.
==> A BULL MARKET is a sustained period of increase in a general index of stock prices (such as the DIA or SPY) lasting several years and pushing prices up 30%, 40%, and often much more. For example the Bull Market since the spring of 2009 has pushed prices up almost 90%. Since such bull markets are associated with economic recoveries they are often called CYCLICAL bull markets.
Now that we have financial data and charts going back over 100 years there has been a lot of attention given to the concept of a Secular Bull Market. Again, such a concept has to be carefully defined before it can be measured and analyzed.
==> A SECULAR Bull market is a lengthy period of increase in a general index of stock prices, often lasting a decade or more, and associated with massive social and economic changes such as the spread of technology, the spread of free market ideology, or reductions in natural resources costs. For example the secular bull market from 1980 to 2000 was associated with lower taxes, deregulation, lower fossil fuel costs, the fall of communism, and increased personal freedom due to the internet. Secular Bull markets can see prices jump many fold times--I remember the Dow at 800 in the early Reagan years!!-- and can contain several cyclical bull and bear markets within them.
My definitions are detailed and informative for a reason. In order for analysis to be scientific, replicable, testable, and meaningful, the concepts we are talking about have to be carefully defined and CAPABLE OF BEING MEASURED. If this does not occur we are just barking opinions at each other. Look at the global warmingists as an example. What is the DEFINITION of Global Warming? How is it measured? No wonder the global warmingists can use heat waves, cold waves, droughts, and floods to prove their 'theory' at the same time! Seeking Alpha readers deserve better.
Of course the Dow Theory talks about Bear Markets as well. We can define them, more briefly since they are mirror opposites of the Bull Markets, as follows:
==> A BEAR MARKET is a sustained period of decline in a general level of stock prices, often lasting a year or longer, associated with declines of 20%, and often much more. A bear market is usually associated with a recession and called a cyclical bear market. The decline from December of 2007 to Spring of 2009 is a good example.
==> A Secular Bear market is a lengthy period of declining stock prices, often lasting a decade or more, associated with periods of political, military and economic turmoil or warfare, and socioeconomic policies hostile to capital formation such as high taxes, regulation, confiscation of assets, poor treatment of patents and innovation, etc. Good example of past secular bear Markets are 1929-1939, and 1966 to 1980. Many people view the anemic performance of stocks since 2000 as a secular bear market, as well.
(2) The next category of market fluctuation in Dow Theory is the secondary reaction, a period of time while prices move counter to the prevailing bull or bear market. In Bull markets we often call these selloffs corrections. In bear markets they have a variety of names, but I will use the term countertrend rally.
One of the criticisms of Dow Theory is that it involves judgment, and the most difficult call a Dow Theorist has to make is whether a selloff (in a bull market) is 'enough' to be properly considered a secondary reaction or not. To me this is not a valid criticism of Dow Theory. ALL INVESTING involves judgment: whether the earnings beat was large enough; whether the debt ratio is small enough; whether the dividend payment is high enough. What dow theory does is force the investor to be consistent with his judgments, and especially to not jump off a bull or bear market primary trend just because prices have moved briefly and unconvincingly in the opposite direction: say, as they did when they rose in late Spring of 2008!
(3) Finally there are the daily fluctuations in prices, which dow theory ignores except in the sense that, over time, the constitute the primary and Secondary trends as outlined above.
Many people believe Dow was inspired by the actions of the tides and waves on the beach, for these reasons the 3 categories above are often referred to as the Tide, waves, and ripples.
Now that I have outlined some basic principles of Dow Theory, let me switch to a more user friendly and visual mode, and apply dow theory to current stock market action. We have to start somewhere, so lets start in Spring of 2009, when investors had surely endured a bear market of nearly 15 months duration. The presumption, therefore, is that a bear market is in progress.
Look at the chart of the DIA for the first nine of months of 2009. What should an investor make of the rally that lasted 4 months starting in March? Is it merely a countertrend rally, or the start of a new bear market? In dow theory, this is answered by putting the rally to a test: if this rally endures a secondary reaction, and prices recover to newer highs, a new bull market may have been signaled. Look at the selloff for several weeks in July/August. In Dow Theory, a secondary reaction has to
(a) be at least several weeks in duration, longer if possible, and
(b) retrace a substantial part of the previous gain.
The mid summer selloff lasted nearly six weeks and it retraced almost one third of the previous gain, so it meets the test (though I agree its still a bit shaky..As I was, looking at the market at this time.) Nonetheless, when prices resumed their upward trend and went to new highs in August, the Dow Industrials signaled the end of a bear market and the start of a new Bull Market.
But that's not quite enough. Not only must the Dow Industrials signal a bull market, the Dow Transportation Index (BATS:IYT) must 'confirm' this bullish signal. This is one of the most celebrated aspects of dow theory and financial pages are so full of comments about confirmation (or lack thereof) ya think the local Bishop has descended on Wall Street and slapped a few traders! But lets see what it means, in a practical fashion. Below is the chart for IYT over the same time period.
Notice we see the same big gain from March till early May. The transports start marking time for almost two months, but also retracing a substantial portion of those earlier gains. Then, YAY!, prices begin to rise and Transports go to a new high in the middle of July! In fact, the transports gave the first buy signal in mid July and the new bull market was confirmed by the Industrials at almost the same time.
Dow insisted on having the two indexes 'confirm' because goods which are being produced (industrials) have to be transported to market and sold (by truck, rail, and airplane).
Thus, using Dow Theory, a long term investor bought DIA around $82, and IYT around $60. With their prices $135 and $89 respectively, not including dividends, the last 3 years have been kind.
What is the Dow Theory currently saying? What about the difficult price action in the summers of 2010 and 2011? You'll see what a challenge measuring a 'secondary reaction' really is! I will address these questions in future articles.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in SPY over the next 72 hours.