CHAPTER 6 – DOW THEORY

Question 1

What are the Six Tenets of Dow Theory?

Answer 1

1. The averages discount everything.
2. Market has 3 trends
3. Primary trend have 3 phases
4. The averages must confirm each other
5. Volume confirms trends
6. A trend should be assume to presist until it gives a difinite signal thats that it has reversed.

Question 2

Describe the history of Dow Theory

Answer 2

Charles Dow started it. Made an index to measure overall price movement in U.S. stocks. He died. Journalist coined “Dow Theory.” Friend took over and attempted to beat Market. People analyzed it and determined he failed. Later on, more people analyzed it and determined he beat it according to risk adjustment and timing market.

Question 3

Discuss the basic principles of Dow Theory

Answer 3

1. Ideal Market picture consists of an uptrend, top, downtrend, and bottom, interspersed with retracements and consolidations.
2. Economic rationale should be used to explain stock market action
3. Prices trend

Question 4

Identify the three basic types of trend identified in Dow Theory as defined by time: primary, secondary and minor

Answer 4

o Primary - Can be several years, longest of the three, represents the overall broad long-term movement of security prices.
o Secondary - intermediate trend that runs counter to the primary. Generally last a few weeks to a few months. Price movement generally retraces from 33% to 66% of the primary price change.
o Minor - A line is two to three weeks of horizontal price movement in an average within a 5% range

Question 5

What are the three major trends in Dow Theory? Which is the most important? Why?

Answer 5

There are three major trends in Dow Theory. First, there is the primary trend. The primary trend is the broad market trend which might last several years. A bull market is a strong primary uptrend and a bear market is a broad downward trend. Second is the secondary reaction, which usually lasts from three weeks to many months. For example, during a primary bull market, a general decline over several months would be a secondary reaction. Third is the daily fluctuation known as the minor trend.
The primary trend is the most important because it represents the overall, broad, long-term movement of security prices. It is the general direction of movement in the market. In a bull market, the general trend is upward. Although there are secondary reactions in which investors experience losses, these reactions are short-lived. For long-run profitability it is more important to be in the position of the long-term movement of the market. The market is not necessarily logical in its movements from day to day, and, therefore, you should ignore the minor trend.

Question 6

What is meant by the term confirmation in Dow Theory?

Answer 6

Dow thought economic rationale should be used in explaining moves in stock prices. Confirmation was the consideration of the industrial and railroad averages together. Confirmation in the Dow Theory occurs when both the industrial and railroad averages reach new highs or new lows together on a daily closing basis. Thus, one average is “confirming” the movement of the other. If industrials were rising, Dow wanted to make sure that the goods being produced were actually being transported (and sold) to customers. Higher production should result in increased transportation activity; if not, firms are simply increasing inventories.

Question 7

What role does volume play in Dow Theory?

Answer 7

Volume is used as a secondary confirmation of trend. Excessively high market prices that are accompanied by less volume on rallies and more activity on declines usually suggest an overbought market. Conversely, extremely low prices with low-volume declines and increased volume on rallies suggest an oversold market.

Question 8

According to Dow Theory, what signals would an investor watch for that would indicate a reversal in the primary trend?

Answer 8

First an investor would look for a failure of confirmation from the industrial and transportation indexes. During a primary uptrend, a failure of the industrial and transportation indexes to make new highs after a secondary reaction would alert the trader to a potential end of the primary up trend. For secondary confirmation, the investor would watch volume. Rallies occurring on low volume and declines occurring on higher volume would be further indication of an end of the primary uptrend.

Question 9

10. One of the criticisms of Dow Theory is that it calls market reversals long after they occur. Explain why Dow Theory makes these market calls late. What are the trade-offs that investors make with a system that tends to make late calls of market reversals?

Answer 9

In an ideal world, a trader would want to buy at the moment an uptrend begins and sell when price peaks and the trend reverses. In the real world, however, expecting to pick the exact beginning and the exact ending of a trend is impossible. Dow Theory tends to make late calls because there is a lag between the actual turn in the primary trend and the recognition of the change in trend. Dow Theory does not recognize a change in trend until after it has occurred and has been confirmed. Thus, investors get into the market after an uptrend begins and exit after the peak in prices. These investors pay a little more for the stock than they would have if they had bought at the bottom. In addition, they sell the stock after the trend has ended for a price lower than the peak price. Dow Theory does not attempt to predict trend changes to try to enter positions at the moment the trend does change. Trying to pick the exact moment of the trend change would result in errors in judgment, high turnover, and increased transaction costs.