Barbican Asset Management – A glimpse at the Dow Theory

SOME weeks ago we had a look at the introduction of the method of technical analysis.


This week we will continue with our series on the same subject but now with

more attention on the Dow Theory.


This theory is instrumental in identifying major trends on the stock market i.e. primary trends. Once established, the trend will be assumed to hold up until there is evidence to prove otherwise. It is important to note that Dow Theory focuses mainly on the direction of the trend and has no forecasting value as to the ultimate duration or size of the trend.


The theory originates from the works of Charles H Dow who used the behaviour of the stock market as a barometer of business conditions rather than as a basis for forecasting stock prices themselves.


The theory assumes that the majority of stocks follow the underlying trend of the market most of the time with few discrepancies resulting from the noise of the process/market. As a way of measuring the market movements Dow constructed two indexes, now code-named the Dow Jones Industrial Average, (originally comprising 12 blue chip counters), and the Dow Jones Rail average, (made up of those counters in the rail road).


The blue chips were however increased to the current number of 30 with the rail average, which was intended as a proxy for transportation stocks being modified to encompass the evolution of aviation and other forms of transport. As a result the index has been later named the Transportation

Average.Interpretation


For a correct interpretation of the theory, there is need to keep track of the daily closing prices of the two averages and the total of daily transactions on the stock exchange. Six basic factors form the doctrine of Dow Theory.

The averages discount everything – The aggregate sentiment or judgment of all stock participants are reflected by the daily changes of closing prices. The underlying assumption is that the process discounts everything known and predictable that can affect demand and supply of the counters. The participants in stock market include both the current and the potential.


Market movements – The stock market is basically characterized by three movement’s i.e. primary, secondary and tertiary trends. Under the Dow Theory the primary trend is of major importance and covers longer periods of more than a year; and


Lines indicate movement – According to Rhea, a line is defined as a price movement two to three weeks or longer during which period the price variation of both averages moves within a range of approximately 5% of their mean. Movements of such a nature are indicative of either, accumulation or distribution. An advance above the limits of the line indicates accumulation and predicts higher prices while the opposite is true.


Price, volume relationships provide background – What is considered as normal is that volumes increase on rallies and while on decline they contract. However, if volumes shrink on a price rise and expands on a fall it’s a warning of a reversal of the current trend. The principle is to be used as back ground information only since the conclusive evidence of a trend reversal can be confirmed only by the price of the respective averages.


Trends are determined by price action – As one author has put it, “Bullish indications are given when successive rallies penetrate peaks while the trough of an intervening decline is above the preceding trough. On the other hand bearish indications come from a series of declining peaks.”


Confirmation of the averages – The Dow Theory puts more emphasis on need for both the Industrial Average and the Transport Average to be considered together. The need for confirming action by both averages would seem fundamentally logical, for if the market is truly a barometer of future business conditions, investors should be bidding up the prices both of companies that produce goods and of companies that transport them in a growing economy.


Conclusion


This article is part of a series of articles to cover the techniques and application of the Dow Theory to making investments decisions.


In the next article we will concentrate on the applicability of the theory to our stock market.

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