Markets are Oceans

This post is part of our series: Modern Dow Theory – Part 1B

 

“The Dow Theory is the granddaddy of all technical market studies. Although it is frequently criticized for being “too late,” and occasionally derided (particularly in the early stages of a Bear Market) by those who rebel at accepting its verdicts, it is known by name to nearly everyone who has had any association with the stock market, and respected by most. Many who heed it in greater or lesser degree in determining their investment policies never realize that it is purely and simply “technical.” It is built upon and concerned with nothing but the action of the stock market itself (as expressed in certain “averages”), deriving nothing from the business statistics on which the fundamentalists depend.”

 

- Robert D. Edwards & John Magee, Technical Analysis of Stock Trends, 9th ed., Chapter Three; The Dow Theory

 

In the previous blog update, we talked about the broad overview and Dow Theory’s beginnings. In this posting, we will ride through the history and the backstory that made this indicator famous, and how they are connected to modern Technical Analysis today.

 

 

More often than not, stocks move together like "schools of fish"

More often than not, stocks move together like “Schools of fish.”

Dow Theory is one of the First Four Principles of Technical Analysis. It is number 4 on our list of the First Principles of Technical Analysis. It deals in what the market as a whole is telling you, and what are the strongest and weakest averages. Dow Theory indicates to the technician the overall market trend, and therefore dictates the types of positions that are the most likely to succeed, as well as signals when the positions should be managed for risk. The concept behind it includes the element of time and trend: that as time passes, company stock will tend to decline when all financial markets decline, and the same stock will tend to rise when markets rise. Charles Dow originally noted that the stocks of the market move together like schools of fish, and this is why his theory can be so valuable. Additionally, it is helpful to understand the strongest and weakest sectors of the market, as the stocks that make up a sector also generally move together. Dow Theory was originally created simply as a “barometer” of market conditions, as they revealed themselves in the averages; it was not initially designed as a predictor of market movement.* As mentioned in the opening quotation, Dow Theory is purely technical; it requires an examination of the flow of the broad market exclusive of other indicators. As stocks move together like fish, the market as a whole can be thought of as the ocean that contains these fish, and both our ocean and financial markets have their own ebbs and flows.

 

 

Dow originally explained his thoughts on the market in the editorials he wrote for The Wall Street Journal. His collected editorials were taken up and published by his successor, and in 1902 William P. Hamilton organized and outlined more than 25 years of market commentary into what is today known as “Dow Theory.” Continuing the aquatic” market theme, Dow Theory conveys further analogies such as the use of waves, major, secondary, and minor trends, peaks/troughs (as of waves), market movements that are described as tides that rise and fall, the raising/lowering of all boats, and trends and cycles that consistently continue somewhat similar to the patterns of the ocean that are generally consistent over time.

 

 

A market can be thought of as an analogy for an ocean

A market can be thought of as an analogy for an ocean

 

The next posting will describe the importance of peak-and-trough analysis and the concepts of high and low “water marks.”

 

*To be clear, Dow Theory does not aim to predict markets. It’s purpose is to reveal the current trend.

 

Modern Dow Theory: Part 1A

This blog posting is part of a three-part series that unveils modern Dow Theory by explaining its genesis, evolution, and permutations while identifying competing ideas and controversial findings. The series will conclude by giving the reader a sense of the direction Modern Dow Theory is headed and how it can be applied practically with examples.

 

 

A lot of academic attention has gone into, and continues to go into, Modern Portfolio Theory, or MPT, and perhaps rightly so. As part of the CMT exams, MPT is a critical aspect for a student studying technical analysis and any acolyte who hopes to one day manage large swaths of the wealthy’s wealth.

 

Trend Analysis

DOW THEORY ON THE MOVE

Modern Portfolio Theory, while not contrary to Technical Analysis, is on the opposite wave length of the study. On one hand, you have the rigidity and exacting science of MPT, while on the other you have the creative and playful “artful science” that is open to vast differences of interpretation otherwise known as Technical Analysis. Nevertheless, MPT plays an important role both to MBA students and apprentices and masters of the markets. Though it is perhaps worth highlighting that the “T” of “MPT” stands for “theory.” While theory has several definitions, the theories in which I am relaying for the purpose of this article are actionable theories:

 

Ideas used to account for a situation or justify a course of action.” -Merriam Webster

 

In any conversation in which discussions of theories dealing with financial markets take place, it always worth mentioning what is in my opinion the Primal Theory of markets, otherwise known as Dow Theory. Without Dow Theory, no basis or justification for investment could ever be made except for mere chance. Long considered the foundation of Technical Analysis, Dow Theory was discovered by the Father of market analysis himself, none other than Charles Dow.

 

PRIMAL, adj. – “of, relating to, or denoting the needs, fears, or behavior that are postulated (especially in Freudian theory) to form the origins of emotional life.” -Google Dictionary

 

 

Dow Theory has its origins in price history charting, utilizing a method of analysis known simply as “peak and trough analysis.” It is this simple method of measuring the a trend that made Mr. Dow famous, and together with Edward Jones, they published analysis and market insights for 20 years on Wall Street through the company they co-founded: Dow, Jones, & Company.

 

 

Handy Brain

The herd moves in unison

 

In today’s conversation, Dow Theory is often referred to as “dated,” or “an old indicator.” In the next posting, you will see why Dow Theory is more modern and relevant than it has ever been, and how being on the wrong side can cost you for many years, even decades. It must be remembered that both Dow and his business partner, Edward Jones, were committed to provide truly unbiased, objective market analysis that average Americans could take to the bank with them. It is in this spirit that Technical Analysis was born and which it remains, making itself available to anyone with the grit and passion to utilize it advantageously and attain greater degrees of financial freedom.