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The sum and tendency of the transactions of the Stock Exchange represent the sum of all Wall Street's knowledge of the past, immediate and remote, applied to the discounting of the future. There is no need to add to the averages, as some statisticians do, elaborate compilations of commodity price index numbers, bank clearings, fluctuations in exchange, volume of domestic and foreign trades or anything else. Wall Street considers all these things (Hamilton, pp. 40–41).
Sound familiar? The idea that the markets reflect every possible knowable factor that affects overall supply and demand is one of the basic premises of technical theory, as was mentioned in Chapter 1. The theory applies to market averages, as well as it does to individual markets, and even makes allowances for“acts of God.”While the markets cannot anticipate events such as earthquakes and various other natural calamities, they quickly discount such occurrences, and almost instantaneously assimilate their affects into the price action.
Before discussing how trends behave, we must clarify what Dow considered a trend. Dow defined an uptrend as a situation in which each successive rally closes higher than the previous rally high, and each successive rally low also closes higher than the previous rally low. In other words, an uptrend has a pattern of rising peaks and troughs. The opposite situation, with successively lower peaks and troughs, defines a downtrend. Dow's definition has withstood the test of time and still forms the cornerstone of trend analysis.
Dow believed that the laws of action and reaction apply to the markets just as they do to the physical universe. He wrote,“Records of trading show that in many cases when a stock reaches top it will have a moderate decline and then go back again to near the highest figures. If after such a move, the price again recedes, it is liable to decline some distance”(Nelson, page 43).
Dow considered a trend to have three parts, primary, secondary , and minor , which he compared to the tide, waves, and ripples of the sea. The primary trend represents the tide, the secondary or intermediate trend represents the waves that make up the tide, and the minor trends behave like ripples on the waves.
An observer can determine the direction of the tide by noting the highest point on the beach reached by successive waves. If each successive wave reaches further inland than the preceding one, the tide is flowing in. When the high point of each successive wave recedes, the tide has turned out and is ebbing. Unlike actual ocean tides, which last a matter of hours, Dow conceived of market tides as lasting for more than a year, and possibly for several years.
The secondary, or intermediate, trend represents corrections in the primary trend and usually lasts three weeks to three months. These intermediate corrections generally retrace between one-third and two-thirds of the previous trend movement and most frequently about half, or 50%, of the previous move.
According to Dow, the minor (or near term) trend usually lasts less than three weeks. This near term trend represents fluctuations in the intermediate trend. We will discuss trend concepts in greater detail in Chapter 4,“Basic Concepts of Trends,”where you will see that we continue to use the same basic concepts and terminology today.
Dow focused his attention on primary or major trends, which he felt usually take place in three distinct phases: an accumulation phase, a public participation phase, and a distribution phase. The accumulation phase represents informed buying by the most astute investors. If the previous trend was down, then at this point these astute investors recognize that the market has assimilated all the so-called“bad”news. The public participation phase, where most technical trend-followers begin to participate, occurs when prices begin to advance rapidly and business news improves. The distribution phase takes place when newspapers begin to print increasingly bullish stories; when economic news is better than ever; and when speculative volume and public participation increase. During this last phase the same informed investors who began to“accumulate”near the bear market bottom (when no one else wanted to buy) begin to“distribute”before anyone else starts selling.
Students of Elliott Wave Theory will recognize this division of a major bull market into three distinct phases. R. N. Elliott elaborated upon Rhea's work in Dow Theory , to recognize that a bull market has three major, upward movements. In Chapter 13,“Elliott Wave Theory,”we'll show the close similarity between Dow's three phases of a bull market and the five wave Elliott sequence.
Dow, in referring to the Industrial and Rail Averages, meant that no important bull or bear market signal could take place unless both averages gave the same signal, thus confirming each other. He felt that both averages must exceed a previous secondary peak to confirm the inception or continuation of a bull market. He did not believe that the signals had to occur simultaneously, but recognized that a shorter length of time between the two signals provided stronger confirmation. When the two averages diverged from one another, Dow assumed that the prior trend was still maintained. (Elliott Wave Theory only requires that signals be generated in a single average.) Chapter 6,“Continuation Patterns,”will cover the key concepts of confirmation and divergence. (See Figures 2.1 and 2.2 .)
Dow recognized volume as a secondary but important factor in confirming price signals. Simply stated, volume should expand or increase in the direction of the major trend. In a major uptrend, volume would then increase as prices move higher, and diminish as prices fall. In a downtrend, volume should increase as prices drop and diminish as they rally. Dow considered volume a secondary indicator. He based his actual buy and sell signals entirely on closing prices. In Chapter 7,“Volume and Open Interest,”we'll cover the subject of volume and build on Dow's ideas. Today's sophisticated volume indicators help determine whether volume is increasing or falling off. Savvy traders then compare this information to price action to see if the two are confirming each other.
Figure 2.1 A long term view of the Dow Theory at work. For a major bull trend to continue, both the Dow Industrials and the Dow Transports must advance together.
This tenet, which we touched upon in Chapter 1, forms much of the foundation of modern trend-following approaches. It relates a physical law to market movement, which states that an object in motion (in this case a trend) tends to continue in motion until some external force causes it to change direction. A number of technical tools are available to traders to assist in the difficult task of spotting reversal signals, including the study of support and resistance levels, price patterns, trendlines, and moving averages. Some indicators can provide even earlier warning signals of loss of momentum. All of that not withstanding, the odds usually favor that the existing trend will continue.
Figure 2.2 Examples of two Dow Theory confirmations. At the start of 1997 (point 1), the Dow Transports confirmed the earlier breakout in the Industrials. The following May (point 2), the Dow Industrials confirmed the earlier new high in the Transports.
The most difficult task for a Dow theorist, or any trend-follower for that matter, is being able to distinguish between a normal secondary correction in an existing trend and the first leg of a new trend in the opposite direction. Dow theorists often disagree as to when the market gives an actual reversal signal. Figures 2.3a and 2.3b show how this disagreement manifests itself.
Figures 2.3a and 2.3b illustrate two different market scenarios. In Figure 2.3a , notice that the rally at point C is lower than the previous peak at A. Price then declines below point B. The presence of these two lower peaks and two lower troughs gives a clear-cut sell signal at the point where the low at B is broken (point S). This reversal pattern is sometimes referred to as a“failure swing.”
Figure 2.3a Failure Swing. The failure of the peak at C to overcome A, followed by the violation of the low at B, constitutes a“sell”signal at S.
Figure 2.3b Nonfailure Swing. Notice that C exceeds A before falling below B. Some Dow theorists would see a“sell”signal at S1, while others would need to see a lower high at E before turning bearish at S2.
In Figure 2.3b , the rally top at C is higher than the previous peak at A. Then price declines below point B. Some Dow theorists would not consider the clear violation of support, at S1, to be a bona fide sell signal. They would point out that only lower lows exist in this case, but not lower highs. They would prefer to see a rally to point E which is lower than point C. Then they would look for another new low under point D. To them, S2 would represent the actual sell signal with two lower highs and two lower lows.
The reversal pattern shown in Figure 2.3b is referred to as a“nonfailure swing.”A failure swing (shown in Figures 2.3a ) is a much weaker pattern than the nonfailure swing in Figure 2.3b . Figures 2.4a and 2.4b show the same scenarios at a market bottom.