The basic tenets of Dow Theory

Press, 19 August 1982, Page 27

The basic tenets of Dow Theory

To get back to the Dow Theory, itself, here are its basic tenets:—

1. The Averages Discount Everything (except "Acts of God") — Because they reflect the combined market activities of thousands of investors, including those possessed of the greatest foresight and the best information on trends and events, the averages in their day-to-day fluctuations discount everything known, everything foreseeable. and every condition which can affect the supply of or the demand for corporate securities. Even unpredictable natural calamities when they happen are quickly appraised and their possible effects discounted.

2. The Three Trends — The “market." meaning the price of stocks in general, swings in trends of which the most important are its Major or Primary Trends. These are the extensive up or down movements which usually last for a year or more and result in general appreciation or depreciation in value of more than 20 per cent. Movements in the direction of the Primary trend are interrupted at intervals by Secondary swings in the opposite direction — reactions or “corrections" which occur when the Primary move has temporarily “gotten ahead of itself." (Both Secondaries and the intervening segments of the Primary trend are frequently lumped together as Intermediate movements — a term which we shall find useful in subsequent discussions). Finally, the Secondary trends are

composed of Minor trends or day-to-day fluctuations which are unimportant. 3. The Primary Trends — These, as aforesaid, are the broad over-all up and down movements which usually (but not invariably) last for more than a year and may run for several years. So long as each successive rally (price advance) reaches a higher level than the one before it, and each secondary reaction stops (i.e., the price trend reverses from down to up) at a higher level than the previous reaction, the Primary Trend is Up. This is called a Bull Market. Conversely, when each intermediate decline carries prices to successively lower levels and each intervening rally fails to bring them back up to the top level of the preceding rally, the Primary Trend is Down, and that is called a Bear Market. (The term bull and bear are frequently used loosely with reference, respectively, to any sort of up or down movements, but we shall use them here only in connection with the Major or Primary movements of the market in the Dow sense).

Ordinarily — theoretically at least — the Primary is the only one of the three trends with which the true long-term investor is concerned. His aim is to buy stocks as early as possible in a Bull Market — just as soon as he can be sure that one has started —

and then hold them until (and only until) it becomes, evident that it has ended and a Bear Market has started. He knows that he can safely disregard all the intervening Secondary reactions and Minor fluctuations.

The trader, however, may well concern himself also with the Secondary, and it will appear later that he can do so with profit.

4. The Secondary Trends — These are the important reactions that interrupt the progress ef prices in the Primary direction. They are the Intermediate declines or “corrections" which occur during Bull Markets, the Intermediate rallies or “reeo.eries" which occur in Bear Markets. Normally they last for from three weeks to as many months, and rarely longer. Normally they retrace from one third to two thirds of the gain (or loss as the case may be) in prices registered in the preceding swing in the Primary direction. Thus, in a Bull Market prices in terms of the Industrial average might rise steadily, or with only brief and minor interruptions, for a total gain of 30 points before a Secondary correction: that correction might then be expected to produce a decline of not less than 10 points and not more than 20 points before a new Intermediate advance in the Primary Bull trend developed.

Note, however, that the one-third — twothirds rule is not an unbreakable law; it is simply a statement of probabilities. Most Secondaries are confined within these limits; many of them stop very close to the halfway mark, retracing 50 per cent of the Primary swing; they seldom run less than one third but some of them cancel nearly all of it. Thus we have two criteria bv which to

recognise a Secondary trend. Any price movement contrary in direction to the Primary trend which lasts for at least three weeks and retraces at least one third of the preceding net move in the Primary direction (from the end of the preceding Secondary to the beginning of this one. disregarding minor fluctuations) is labeled as of Intermediate rank. i.e. a true Secondary. Despite these criteria, however, the Secondary trend is often confusing; its recognition, its correct appraisal at the time it develops and while it is in process, poses the Dow Theorist's most difficult problem.

5. The Minor Trends — These are the brief (rarely as long as three weeks —

usually less than six days) fluctuations which are — so far as the Dow Theory is concerned — meaningless in themselves, but which in toto make up the Intermediate trends. Usually, but not always, an Intermediate swing, whether a Secondary or the segment of a Primary between successive Secondaries, is made up of a series of three Or more distinguishable Minor waves: Inferences drawn from those day-to-day fluctuations are quite apt to be misleading. The Minor trend is the only one of the three trends which can be "manipulated” (although it is, in fact, doubtful if under present conditions even that can be purposely manipulated to any important extent). Primary and Secondary trends cannot be manipulated: it would strain the resources of a Government to do so.