Dow Theory & The Bull/Bear Market Cycle

Question 1

What did Charles Dow do?

Answer 1

He used price behaviour in the stock market as a barometer of economic business conditions. He was only concerned with the market direction, not the size or duration of the trend.

Question 2

How did Charles Dow determine the health of the economy?

Answer 2

He made the Dow Jones Industrial Index and the Dow Jones Transportation Index. He needed to see both indices performing well to confirm the health of the economy

Question 3

Principles of Dow theory

Answer 3

1. The averages discount everything except acts of god
2. There are 3 types of trend
3. Major trends go through three phases
4. Volume should confirm the trend
5. Price action determines the trend
6. The averages must confirm each other
   He also noted that a trend stays in place until it shows a definite sign of reversal

Question 4

Dow theory pros and cons

Answer 4

+it aims to identify major new trends and capture the large middle section of market moves
+larger profits can be made when trading with the long term trend
+Dow buy signals are only given once weight of evidence is strong
-trade signals are only generated after 20-25% of the trend has been completed

Question 5

What is the relationship between equity markets and economic cycles?

Answer 5

Equity prices tend to anticipate economic cycles

Question 6

What are the key things we can measure the health of the market with?

Answer 6

Market prices
Dominant emotions
Retail investors
Progressional investors
Economic conditions

Question 7

Bull phase 1 characteristics

Answer 7

• market prices start to recover after falling for a long time
• emotions are scepticism and suspicion
• retail investors are annoyed with the market so stay away from it
• professional investors recognise stocks are at bargain prices and so buy
• bad news is still coming out and the economy is continuing to deteriorate

Question 8

Bull phase 2 characteristics

Answer 8

• market prices rise strongly on increasing volume
• growing recognition and confidence
• retail investors start to buy stocks
• professional investors accelerate their buying
• fundamental business conditions are improving and investors realise that economic prospects are positive

Question 9

Bull phase 3 characteristics

Answer 9

• stock prices are still rising but the uptrend is slowing. Volume starts to diminish on rallies and increase on pull backs
• over enthusiasm and conviction
• retail investors are over excited and keep buying
• professional investors start selling stocks at high prices
• fundamentals look extremely positive but market expectations are even higher

Question 10

Bear phase 1 characteristics

Answer 10

• market prices start to fall
• disbelief
• retail investors still feel bullish and buy as the prices fall
• professional investors increase their selling
• fundamentals are looking less positive with increasing number of companies issuing profit warnings

Question 11

Bear phase 2 characteristics

Answer 11

• price a eels rate lower as investors rush out of the market
• panic, shock, fear
• retail investors start to sell as they panic
• professional investors join the panic by selling everything
• business conditions are worse than expected, profits down and unemployment up

Question 12

Bear phase 3 characteristics

Answer 12

• market prices keep falling but the decline slows. Occasional rallies occur but these can’t be sustained
• disgust, disillusionment
• retail investors finally sell all their shares at big losses
• professional investors continue to sell into any rallies
• business conditions have deteriorated further and the outlook is bleak