4 Misconceptions about Dow Theory
- Posted by DynamicHedge
- on July 3rd, 2014
Dow Theory is well known by most market technicians. Like most investing frameworks, people tend to cherry pick the rules that suit them at the time rather than taking time to deeply study and understand it. This is probably partially due to the fact that the tenets of Dow Theory were assembled posthumously, and thus the entire theory could be called an interpretation. You see, Charles Dow never organized his theories into a book during his lifetime. Several technicians after Dow organized and developed Dow’s articles published on the Wall Street Journal into what is now considered “Dow Theory”.
There are six basic principles in Dow Theory and they all have their own way of getting twisted.
The most common misconceptions are:
- The Dow Transportation index is a supremely powerful calculation that will always save you from being head faked by the market.
- Dow Theory provides advance warning of trend reversals.
- Spotting divergences is the primary application of Dow Theory.
- Low volume is always a bad thing.
- The Averages Discount Everything.
An individual stock’s price reflects (or discounts) everything that is known about the security. So, does this mean that Dow was an EMH proponent? Not quite. This rule is simply stating that you can rely on price as the primary transmission mechanism for what is known about the security — particularly if you’re dealing with a basket of securities or index. No need to look on the balance sheet or income statement because everything you need is in the chart itself.
No real misconceptions here as this is basically a catch-all truism posing as deep insight. There is potential for a lot of debate around this topic..
- The Market Has Three Trends.
Dow considered a market trend to have three parts: primary trend, secondary trend and minor trend.
Primary trend indicates the major trend of the market which usually lasts for more than one year. Secondary trend, also called intermediate trend, is corrective move within the major trend, which means it moves in the opposite direction of the major trend. It usually lasts three weeks to three months. Minor trend is a correction to secondary trend which usually lasts for less than three weeks.
Look at above figure. 1-2-3-4 represents the major trend. Corrective phase 2-3 is intermediate correction within the major trend. Intermediate trend (2-3) is divided in minor trends A-B-C.
Dow Theory does not give advance warning or trend reversals. If anything, it’s designed to keep you in the “real” trend for as long as possible, but no longer. There are no real codified rules but the key is that trend changes are measured in weeks and months. Dow theorists align themselves with catching the fat middle of the trend and leaving the tops and bottoms to others.
3. Major Trends Have Three Phases.
Dow mainly focused on the primary trend, which he considered to take place in three phases: an accumulation phase, a public participation phase, and a distribution phase.
An accumulation phase occurs when informed investors buy near the end of bearish market where no one else left to buy. Once the uptrend is gaining momentum and bull information is obvious, most trend-followers will begin to enter the market. This phase is called the public participation phase. When the bullish market continues to be strong and volumes increase, the same informed investors begin to distribute before anyone else starts to sell. This is called the distribution phase.
This is a reduction rule to help traders avoid getting whipsawed around in their position and yet it is probably the most ignored rule of all. There is not state of the market knows as “due for a correction” or “this market will rip since the Fed is buying assets”. Focus on the basics and don’t try and outsmart the market.
4. The Averages Must Confirm Each Other.
Here, the averages refer to traditional Dow Industrial Average and Rail Average. In Dow theory, Dow indicated that a bull or bear market signal could only take place when both averages gave the same signal. If the two averages are in conflict, there will be no clear signal for the beginning of a bull or bear market.
Most misconceptions involve something to do with the Transports and how they play into the formula. The Transports tend to be more sensitive than the Industrials when it comes to economic data. Many traders use this as an excuse to put laser focus on Transports and consider the Dow separately. Everytime the Transports get weak, traders get overly nervous — even when the Industrials are strong. Dow Theory is very clear that the two averages should confirm each other. When they don’t confirm each other it doesn’t mean the market will suddenly do the opposite, it means that a reliable conclusion cannot be reached.
5. Volume Must Confirm the Trend.
Volume is an important factor of price action. Dow used volume to confirm the price signals. In a major uptrend, volume should increase as price rises and decrease as price falls. In a major downtrend, volume should increase as price falls and decrease as price bounces back.
If there is low volume it means that the market is broken. This is the tired premise on which all manner of malformed arguments are formed. Why is this rally unsustainable? No volume. Why is <insert evidence that contradicts my outlook>? Low volume.
We are operating in a largely low volume, low volatility environment. Volume is relative. Think of this rule as a more a participation litmus test. Is the trend change accompanied by significant turnover in ownership? If yes, then volume is confirming.
6. A Trend Is Assumed to Be in Effect Until It Gives Definite Signals That It Has Reversed.
This tenet refers to the primary trend should be maintained until some external forces cause it to change direction. A major uptrend still has a strong bull momentum even if it is under intermediate correction. Capturing the major market trend is crucial for traders who want to success in the stock market.
This one goes back to the misconception that Dow Theory can provide some sort of advanced warning. Here we see that non-confirmation and intermediate correction is not necessarily a signal for buying or selling. Intermediate weakness or non-confirmation between two averages only implies a warning of a possible reversal. These are often temporary states that can be corrected. The current major trend is still considered in work until it is reversed with a movement above or below the high or low of intermediate correction. For example, with a major uptrend, although there is a non-confirmation between two averages, a sell signal should be present until a move below the low of intermediate correction.
It’s not perfect, but Dow Theory has successfully captured many market moves over the long run. If you use it as a standalone framework it still works well as a trend following strategy. It will rarely generate a timely reversal signal and misses much of move but trend-followers usually enter the market in the second leg. and Dow Theory is focused on on capturing the big moves rather than anticipate the trend getting chopped up along the way.
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DynamicHedge is an equities, futures and derivatives trader based on the West Coast. He runs a long/short opportunistic relative-value strategy within a proprietary trading group. More
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