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CHAPTER 2
Introduction to Dow Theory
2.2 BASIC ASSUMPTIONS OF DOW THEORY

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There are six basic tenets of Dow Theory, namely:

1. The averages discount everything.

2. The market has three trends.

3. Primary trends have three phases.

4. A trend persists until its reversal is indicated.

5. The averages must confirm one another.

6. Volume must confirm the trend.

In addition to the six basic tenets, only closing prices are recognized in Dow Theory.

The Averages Discount Everything (Pricing in Information)

It is believed that the markets discount everything, except acts of God. This means that the market is the end result of all participatory action, which represents all information that may be known to the markets. The mechanism by which information is known to the market is that of actual participation via capital injection. Although the market cannot discount unexpected events, that is, acts of God or unknown information, it can absorb, react, and adjust to market shocks fairly rapidly. The pricing of all known information need not be instantaneous or be driven by rational participants. There is also no requirement that all participants always act on all information all of the time, or that they react in the same manner.

Figure 2.1 depicts prices declining before September 11, 2001. Is the market trying to discount information that is not as yet known or is it merely coincidental?

Figure 2.1 Is the Market Discounting Unknown Information?

Figure 2.2 shows the gold market adjusting very rapidly to information about the same event. The market is attempting to discount all information once the information is made known to it.

Figure 2.2 Gold Adjusting Rapidly to New Information.

In short, the market action is the sum of all participatory activity, based on the aggregate of the participants’ beliefs, biases, personal predilections, as well as future expectations. Price is the ultimate reflection and embodiment of everything that is knowable. As such, the technical analysts need not concern themselves with the causes or circumstances giving rise to various market action, but only with the effects of the underlying causes.

The Market Has Three Trends

The second assumption of Dow Theory is that the market comprises three trends. Robert Rhea explains, in his book The Dow Theory:

There are three movements of the averages, all of which may be in progress at one and the same time. The first, and the most important, is the primary trend: the broad upward and downward movements known as bull or bear markets, which may be of several years’ duration. The second, and most deceptive movement, is the secondary reaction: an important decline in a primary bull market or a rally in a primary bear market. The reactions usually last from three weeks to as many months. The third and usually unimportant movement is the daily fluctuation.

Summarizing, the market is believed to express itself as three distinct trends, namely:

1. Primary trend (major trend) – lasting from months to years (long term)

2. Secondary reaction (intermediate trend) – lasting from weeks to months (medium term)

3. Minor trend – lasting from days to weeks (short term)

See Figure 2.3.

Figure 2.3 All Three Trends in the NYSE Composite Index.

(1) The Primary Trend

The largest trend is by far the primary trend, which is normally expected to last from months to years. Rhea hypothesized that primary trends are not susceptible to manipulation and therefore represent a more reliable barometer for investment decisions. It is sometimes referred to as the tides of the oceans. Although the primary trend usually lasts from months to years, Rhea commented that is it very difficult to forecast the extent or duration of a primary trend.

There are two types of primary trends, namely:

1. Primary bull trend (bull market)

2. Primary bear trend (bear market)

In Dow Theory, an uptrend is defined primarily as successively higher peaks and troughs. A downtrend is defined as successively lower peaks and troughs. Notice in Figure 2.4 that the appearance of a lower high in an uptrend may represent an early indication that the uptrend may be coming to an end.

Figure 2.4 An Uptrend in Terms of Successively Higher Highs and Lows.

In Dow Theory, an indication of a trend continuation or reversal is signaled by the penetration of a previous peak or trough. As such, one of the main criticisms of Dow Theory is that buy and sell signals arrive too late, usually missing out on one-third or more of the entire trend. According to Dow, it is more important to participate in a primary bull or bear trend once it has been confirmed or once it proves that it has the strength to penetrate old peaks or troughs. Dow believes that losing out on some potential profit for the added safety of participating in a confirmed trend is well worth the sacrifice. It should also be noted that all investment and trading decisions are based strictly on the primary trend alone, with the exception of trading lines that may form from the daily price fluctuations. See Figure 2.5.

Figure 2.5 Buy and Sell Signals Based on Dow Theory.

Figure 2.6 depicts a primary bull trend in gold that lasted approximately 12 years.

Figure 2.6 A Primary Bull Trend in Gold.

Figure 2.7 depicts a primary bear trend in the 30-year Treasury bond yield that lasted approximately 23 years.

Figure 2.7 A Primary Bear Trend in the 30-Year Treasury bond Yield.

It should be noted that if trends are defined via trendline violations rather than by the successive sequence of rising or falling peaks and troughs, there may be some discrepancies between exactly when a change in trend actually occurs, especially when different chart scaling is employed. Logarithmically scaled charts tend to give earlier trend change signals since uptrend lines are violated sooner. Conversely, arithmetically scaled charts tend to give slower trend change signals as uptrend lines are violated much later. See Figures 2.8 and 2.9.

Figure 2.8 Bull Market Turning into a Bear Market with Early Trend Change Signals on a Logarithmically Scaled Chart of the Nasdaq 100 Index.

Figure 2.9 Bull Market Turning into a Bear Market with Late Trend Change Signals on a Arithmetically Scaled Chart of the Nasdaq 100 Index.

Sometimes it may be hard to decide which scaling to use in order to apply technical overlays in a manner that would provide consistent signals. If an analyst has been using logarithmically scaled charts on a regular basis, his or her interpretation of the price action may differ from an analyst who regularly uses arithmetically scaled charts. Figures 2.10 and 2.11 show Apple Inc. displaying a more bearish flattening-out-type behavior on a logarithmically scaled chart, whereas the arithmetically scaled charts depict a stronger and steadier uptrend for the same stock over the same period.

Figure 2.10 Bearish Flattening Type Action on Apple Inc.

Figure 2.11 Non Flattening Type Action on Apple Inc.

(2) The Secondary Trend or Reaction

The secondary trend is also referred to as the secondary reaction because it moves or reacts in the opposite direction of the existing primary trend. It usually lasts from weeks to approximately three months, and frequently slightly longer. It is sometimes referred to as the waves on the tides. The secondary reaction usually retraces from one- to two-thirds of the primary trend’s range. Any retracement or correction beyond two-thirds on high volume usually signifies that the secondary reaction may in fact be a new primary bear market. It is important to note that Dow Theory also stresses the importance and psychological significance of the 50 percent retracement level, a view shared by another prominent technician, W. D. Gann.

A primary bull trend resumes its uptrend once price breaches the highest peak formed by the secondary reaction, while a primary bear trend resumes its downtrend once price breaches the lowest trough formed by the secondary reaction. Figure 2.3 showed the NYSE Composite Index resuming its primary bull market around the beginning of 2011 after breaching the peak formed during the formation of the secondary reaction. Figure 2.12 depicts a 75 percent secondary reaction on the Dow Jones Industrial Average. The primary bull market resumes its uptrend upon breaching the highest peak formed during the secondary reaction.

Figure 2.12 Primary Bull Market Resuming Its Uptrend after Breaching the Highest Peak of the Secondary Reaction on the Dow Jones Industrial Average.

Figure 2.13 depicts various secondary reaction retracements in the EURUSD.

Figure 2.13 Secondary Reactions on the EURUSD Daily Chart.

(3) The Minor Trend

The minor trends are not regarded as important in Dow Theory. In fact, Hamilton commented in his book, The Stock Market Barometer, that “The stock market is not logical in its movements from day to day.”

Minor trends usually last from days to weeks. They are sometimes referred to as the ripples on the waves.

Under Dow Theory, the day’s erratic fluctuations represent market noise and no investment decision should be based on such erratic activity, with the exception of lines being formed. Lines are simply narrow horizontal ranging formations on the daily chart. They are usually formed in anticipation of some significant news or economic announcement. These narrow consolidations usually result in strong breakouts. Dow Theory recognizes lines as potentially profitable formations, even though they are essentially regarded as minor trends. A line is the only tradable formation under Dow Theory other than inflection point breakouts in the primary trend. See Figure 2.14.

Figure 2.14 Example of a Line on the Daily Chart of the GBPUSD.

We see that each of the three trends is defined by its duration and extent. We shall now look at primary trends in a little more detail.

Primary Trends Have Three Phases

Primary or major trends have three phases. A primary bull or bear market consists of the following three phases:

1. Accumulation phase

2. Trending phase

3. Distribution phase

Accumulation normally occurs after a deep and rapid decline in prices following companies releasing very negative data. The uninformed market participants are usually extremely bearish at this point, selling off whatever shares they have left at any price available. The better informed market participants start accumulating shares at extremely cheap prices. The accumulation phase normally lasts longer than the distribution phase due to less capital and profit at risk.

The trend phase consists of the uptrend and downtrend phase. The uptrend phase is driven by market participants expecting higher prices after an accumulation. The initial general sentiment tends to be slightly less bearish. The public begins to participate as rising prices becomes more obvious and as more bullish news is reported. At higher prices, margin debt starts to increase as the public scrambles to invest in the rapidly rising market. The uptrend phase tends to last longer than the downtrend phase due to less capital and unrealized profit at risk, at lower prices.

The downtrend phase normally starts to accelerate as more companies start to report increasingly bearish news. The uninformed traders and investors begin to unload positions. As prices begin to fall unexpectedly, the public begins to liquidate positions. Bearish sentiment continues to intensify as prices sink to new depths. The downtrend phase tends to be shorter lived than the uptrend phase, due to the larger amounts of capital and unrealized profit at risk, at higher prices.

Distribution normally occurs after a prolonged and rapid rise in prices. Companies tend to outperform and most media and news headlines are extremely bullish. The uninformed market participants tend to be extremely optimistic, buying up whatever shares are available in the market at any price, normally referred to as being in a state of irrational exuberance. Margin debt is at extreme levels. The smart investors continue to liquidate shares in a very gradual manner during the distribution process, again careful not to drive down prices too rapidly so that they may continue to sell at the higher prices. The distribution phase is normally shorter in duration than the accumulation phase, due to the larger amount of capital and unrealized profit at risk at higher prices, at the top of the market. See Figure 2.15.

Figure 2.15 The Idealized Three Phases of a Primary Bull Trend.

Also, the longer the accumulation or distribution lasts, the greater will be its subsequent breakout move. See Figure 2.16.

Figure 2.16 A Real World Example of the Three Phases of a Primary Bull Trend.

A Trend Persists until Its Reversal Is Indicated

In Dow Theory, a trend is assumed to persist until there is evidence to the contrary. Trend changes are identified by a penetration of a previous significant peak or trough. Therefore, unless a prior support or resistance level is breached, the trend is assumed to be still intact. See Figure 2.17.

Figure 2.17 Primary Bull Trend Terminated with a Violation of a Prior Support Level.

There are basically three types of reversal formations that will signal a change in the direction of the existing or predominant trend, namely:

1. Failure swings

2. Non-failure swings

3. Double tops/bottoms

The term failure swing was first used by Welles Wilder in his book, New Concepts in Technical Trading Systems, when describing the oscillator swings on the relative strength index (RSI) indicator. The three basic top reversal formations are illustrated in Figure 2.18. A breach of a prior support signals a potential change in the direction of the trend. It also represents a technical sell signal. Note that the non-failure swing formation provides a more conclusive sell signal at the penetration of the second or lower support level, rather than at the first higher support level. This is because the formation was still in the process of making a higher peak, so more evidence is required to ascertain that a potential trend change is indeed on the way. Nevertheless, many traders use the first higher support level to scale in or out of some positions, with the remainder of the position scaled in or out at the breach of the second lower support level.

Figure 2.18 Top Reversal Patterns.

The three basic bottom reversal formations are illustrated in Figure 2.19. The same rationale applies except in reverse.

Figure 2.19 Bottom Reversal Patterns.

The Averages Must Confirm One Another

In Dow Theory, there is a requirement that both the Industrials Average and the Railroad Average must extend beyond their secondary peaks in order for a trend to be established, that is, the trend in one average must be confirmed by the other average. In Figure 2.20, we observe that the Industrials Average penetrated its secondary peak at T1 while the Railroad Average penetrated its own secondary peak a little later at T2. Hence the uptrend was only confirmed at time T2. As far as Dow Theory is concerned, the uptrend was not confirmed until the Railroad Average penetrated its own secondary peak at T2.

Figure 2.20 Confirmation of the Averages.

In Figure 2.21, we observe that the Dow Jones Industrial Average breached its own secondary peak at T1, which was confirmed later by the Dow Jones Transportation Average breaching its own secondary peak at T2. It is at T2 that the uptrend in the markets was finally confirmed, according to the tenets of Dow Theory.

Figure 2.21 Confirmation of Trend Continuation Based on Dow Theory.

In Figure 2.22, we observe that the Dow Jones Industrial Average experienced a weak non-failure swing sell signal, signifying a change in the trend. The bearish signal was not confirmed by the Dow Jones Transportation Average and this was therefore regarded as a bullish indication. There is non-confirmation of a reversal in the trend. The Dow Jones Industrial Average subsequently resumed its uptrend after penetrating its own secondary reaction peak.

Figure 2.22 Non-Confirmation of Reversal in Trend on the Dow Jones Industrial Average.

The concept of confirmation may also be applied to closely correlated markets. In Figure 2.23, we observe that the change in trend in silver was not as yet confirmed by gold, a closely correlated market. This may be viewed as either a bearish signal for gold or a bullish signal for silver. A penetration of gold’s support would generally be a bearish sign for silver.

Figure 2.23 Non-Confirmation Between Gold and Silver.

In Figure 2.24, we see an example of the Russell 2000 Small Cap Index not confirming the sell signals in the S&P500 Large Cap Index. This may be regarded as bullish for the S&P500. Although both the S&P500 and Russell 2000 have experienced deep reversals, this non-confirmation may be construed as an oversold indication on the S&P500.

Figure 2.24 Non-Confirmation of a Trend Reversal between the S&P500 Large Cap Index and Russell Small Cap Index.

Volume Must Confirm the Trend

In Dow Theory, volume has to increase or expand in the direction of the existing trend, that is, volume has to confirm the trend. If volume does not expand in the direction of the existing trend, then this is seen as a sign of weakness in the trend and may potentially lead to a weakening or reversal of the existing trend. It should be noted also that volume is considered to be a secondary indicator.

Expanding in the direction of the existing trend means that:

1. In an uptrend, volume should be increasing.

2. In an uptrend, volume should be decreasing during a downside retracement.

3. In a downtrend, volume should be increasing.

4. In a downtrend, volume should be decreasing during an upside retracement.

If any of the four conditions listed above is not met, the existing trend may be potentially weaker than expected and may lead to a reversal in the existing trend. In Figure 2.25, we see volume, in area A on the chart, expanding in the direction of the existing primary bull trend in gold. Notice that on average, volume has declined during the retracement phase, as seen in area B on the chart. This is essentially a bullish indication for gold. We therefore expect more upside moves in gold over the longer term.

Figure 2.25 Volume Expanding in the Direction of the Existing Primary Bull Trend in Gold.

Figure 2.26 illustrates the volume action associated with the primary bull trend between 2006 and 2010 in the GLD SPDR Gold Trust Shares. We see volume expanding in the direction of the trend in period 1, 3, 7, and 9. For periods 2, 4, 6, 8, and 10 we see volume declining whenever there is a correction or retracement in the GLD ETF, which is bullish. This all fits in perfectly with the assumption that GLD was in a primary bull market between 2006 and 2010 and is an extremely bullish indication for GLD. GLD subsequently went north to over $180 per share.

Figure 2.26 Volume Expanding in the Direction of the Existing Primary Bull Trend in GLD SPDR Gold Trust Shares.

Only Closing Prices Are Recognized

In Dow Theory, only closing prices are recognized. This means that regardless of how large the high and low price excursions may be on any one day, only the final closing price will be used. Furthermore, it does not matter how miniscule the amount that price closes above or below the previous day’s closing price.

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Читать книгу The Handbook of Technical Analysis + Test Bank - Lim Mark Andrew - Страница 24

CHAPTER 2Introduction to Dow Theory2.2 BASIC ASSUMPTIONS OF DOW THEORY

CHAPTER 2
Introduction to Dow Theory
2.2 BASIC ASSUMPTIONS OF DOW THEORY