The Value Chronicles Episode 13 – Dow Theory on trend

Dow Theory

The Dow theory on stock price movement is a form of technical analysis that includes some aspects of sector rotation. The theory was derived from 255 Wall Street Journaleditorials written by Charles H. Dow (1851–1902), journalist, founder and first editor of The Wall Street Journal and co-founder of Dow Jones and Company. Following Dow's death, William Peter Hamilton, Robert Rhea and E. George Schaefer organized and collectively represented Dow theory, based on Dow's editorials. Dow himself never used the term Dow theory nor presented it as a trading system.

These editorials were entries on how he believed markets behaved. His theory has six basic tenets which I will explore alongside technical analysis.

The three major primary phases

The most vital trend is the primary trend, (the very long line indicating the upward trend in the Apple inc share graph) which has 3 main phases,

• The accumulation phase
• The public participation phase
• The excess phase

I will start looking at the 3 phases for the bull market or primary upward trend as shown in the Apple Inc graph

Three phases in a bull market

The accumulation phase
The first part of the accumulation phase occurs just before the start of the upward trend. There is normally poor news and everything seems dark and gloomy. It is at this point where informed investors enter the market and the begin the new uptrend. At this point the price is attractive relative to the value of the share as all bad news has been priced.

The problem is that this phase normally occurs after a downwards move, but the uptrend after this move can be a deadcat bounce or the pullback before the continuation of the downtrend.

To be a candidate for this phase there should be a higher low. I give an example using USOIL.

At the bottom of the downtrend there was a reversal with an accumulation currently in the $40 - $50 range.

Public Participation Phase
When the investors entered the market during the accumulation phase, they did hoping that the worst was behind them and that the stock too hard a beating. The only path in front of them is a recovery phase. As the recovery phase plays out, the new primary trend starts to take shape. This recovery phase is known as the public participation phase.

During this phase, negative sentiment starts to dampen as business conditions improve. This is normally seen in the news where good economic data is released and the pessimism starts to wane. The not so informed investors start investing at this point. It is normally the longest phase and a confirmation of the upward trend.

The Excess Phase
After a strong move on the improved economic and business conditions there is a stage of irrational exuberance. The accumulation and public participation phases has past and investors now entering to ride the wave occurs. It is at this point where the early investors scale back their positions, selling it to these late comers. The normal man in the street jumps on board and sends the price higher.

The perception is normally nothing can go wrong and the market will continue to run. These final buyers are buying near the top, after the large gains have already occurred.

Three phases in a bear market

The three phases are identical to the bull market, but are called by different names.
The phases are,

• The distribution phase
• Public participation phase
• Panic phase

The distribution phase is where informed investors with knowledge of the market sell their positions. The public participation phase is where the rest of the market follows the confirmed downtrend. The final phase is where investors dump their shares amid very poor market sentiment.

This is exactly as above, but the phases are mirrored.

As a point of interest it looks as if oil is in the excess phase and will fall back soon.

Till next time,
Tinus

** Images courtesy of tradingview.com