The theory had its beginnings in editorials written from 1900 to 1902 by
Charles H. Dow in the Wall Street Journal. Dow’s good friend S. A. Nelson
tried to persuade him to put these ideas into a book. Dow resisted, and
so Nelson wrote it himself. He published The ABC of Stock Speculation
in 1903 following Dow’s death the previous year. The book included 15 of
Dow’s seminal Wall Street Journal editorials on the subject of speculation
in the market. It was in this book too that Nelson first coined the term
“Dow Theory.” The theory was subsequently expanded upon and refined
by William Peter Hamilton, Dow’s understudy and the editor of the Wall
Street Journal, in editorials titled “The Price Movement,” as well as in his
book, The Stock Market Barometer, published in 1922. However, it was
left to Robert Rhea to organize and summarize the theory more fully. Rhea
was confined to bed for many years with tuberculosis and a damaged lung.

He used this time of enforced physical inactivity for study of business and
the markets and to hone his understanding of the trends that, according
to Dow and Hamilton, characterize the market. In his 1932 book, The Dow
Theory, Rhea wove together the various strands of the theory, including
252 editorials by both Dow and Hamilton, setting them out in a structured
way designed to be of practical use to the individual investor. As mentioned
above, it was in Rhea’s 1934 work The Story of the Averages, that he used
ocean metaphors to describe the three basic trends of Dow Theory. “I like
to think of Dow’s three movements as being the tide, the wave, and the
ripple, all acting, reacting, and interacting at the same time. Consider a
rising tide: as part of the tide we may have an oncoming or a receding
wave, but on the wave may be an incoming ripple, or perhaps a ripple acting
against the tide.”

According to both Hamilton and Rhea, there are certain key assumptions
that need to be accepted in order to understand and use Dow Theory.
The theory asserts that the primary trend of the overall market cannot
be altered through market manipulation, even though individual stocks
are subject to short-term and even medium-term manipulation. A focus
on market manipulation today seems a little antiquated and a reflection
of the times in which the Dow Theory was formulated, the late 19th century,
when market manipulation indeed was rife. Today the market is much
broader and deeper compared to what it was over 100 years ago or during
the Depression pre-World War II time of Rhea’s writing, so manipulation of
the entire stock market today would appear to be a much more ambitious
and probably impossible endeavor. It is true that individual stocks can be
manipulated, particularly smaller stocks, through accounting fraud, the deliberate
spreading of rumors, and big investors deciding to act in concert

while taking short positions. Also individual market manipulations such as
the Hunt brothers’ attempt to corner the silver market in 1980 or the manipulation
of California’s Energy market in 2000 and 2001 by Enron and
other energy trading companies are perfectly possible to envisage in modern
times. Manipulation of the overall U.S. stock market today, however,
appears to be a concept lacking any real feasibility.

Another major assumption that followers of the theory are advised
to accept is that every known fact is already discounted in the market.
In other words, stock prices reflect all available information, including all
hopes, disappointments, fears, and other emotions of market participants,
as well as all extant knowledge of economic factors. These include interest
rate trends and earnings expectations for all companies quoted on the
market. Political events such as presidential elections and domestic and
external strife are also included. Only the unknown and unknowable, such
as catastrophic “Acts of God” are not reflected in current prices.

A third assumption that adherents to Dow Theory accept is that the
Theory itself is not infallible. It can guide the investor in his understanding
of what the trends mean, but is not immutable science.
The Dow Theory concentrates on identifying the primary trend because
followers of the theory believe that the correct recognition of that
trend is the best means to making money in the market. As Rhea put it, “The
correct determination of the direction of this movement (primary trend)
is the most important factor in successful speculation.” These primary
trends can last many years, and correspond to what is usually termed either
a bull or bear market. In Dow’s day, these terms had not yet come into use
and the primary trends were still generally called “booms” and “panics.” In
Rhea’s parlance, the primary trend is like a “tide,” and the point at which
the primary trend changes from bull to bear or vice versa is described aptly
as a turning of the tide.

Secondary “reactions” move against the prevailing primary trend for a
time, with a life span of perhaps a few weeks to several months. These are
called market corrections when they are on the downside and go against
a prevailing bull market—or market rallies when on the upside against a
prevailing bear market. Robert Rhea dubbed these moves waves. For Dow
Theorists, secondary reaction moves are considered to be the means by
which the market ensures that excessive speculation and possible overheating
or cooling of markets is kept in check. Of course, there is always
the possibility that corrections and rallies are mistakenly identified as a
change in the primary trend; but it is one of the aims of Dow Theory to
identify these trends correctly in order to ensure that speculative market
activity takes advantage of them and is not stymied by them. This is not
very easy to do, however, as even the staunchest followers of the Dow

Theory would admit. Rhea considers the secondary reaction as the “most
deceptive” of trends.

Finally, there are daily fluctuations that can move with or against the
primary or secondary trend. Their defining characteristic is that they are
short-lived, lasting from a few hours to a few days, and then reverse themselves.
In Rhea’s lexicon, these fluctuations are the ripples. According to
Dow Theory, while short-term market movements can be useful when
grouped together to aid analysis of the bigger picture of secondary or even
primary moves, these ripples are insignificant when identified or analyzed
on their own. Followers of Dow Theory believe that these short-term fluctuations
have no real importance or value in pointing to primary or even
secondary trends and are no more than background noise. Rhea was certainly
very dismissive of any attempt to make money by exploiting these
short-term fluctuations:
It will be seen that these minor movements rally and decline, back
and fill, and generally perform in a manner most perplexing to the
man who is trying to watch each day’s fluctuations in hopes of scalping
a few dimes out of a few shares of stock while paying commissions,
taxes and brokerage.

In retrospect, Rhea can be viewed as the first observer of markets to have
provided a strong critique of day trading as a money-making practice.

Bulls and Bears
Dow Theory sets out three distinct stages to a primary trend bull market as

Stage 1: Accumulation. This is the first budding stage of a bull market or
“boom” in the vernacular of Dow’s day, when there is still great pessimism
regarding the future. As expectations rise that things will improve,
stock prices begin to rise also. There is increasing recognition
that a bull market is underway. Nevertheless, this growing optimism is
tempered by lingering fears and doubts that what is happening is simply
a rally within a continuing bear market. This is the stage when the
smartest and most perceptive of value investors see their opportunity
to come into the market at cheap levels.

Stage 2: General advance. This stage takes hold as improving business
conditions and a boost in business confidence increase valuations in
stocks. Here trend followers buy in as the market consistently makes
new highs and the investing public is filled with increasing confidence.

Stage 3: Excess. Speculation is rampant and pushes the market ever higher.
Valuations are excessive and the general public is fully involved in the
market. Everyone believes that a new era is at hand and all are overly
optimistic regarding the future. This sounds like Alan Greenspan’s “irrational
exuberance” and will be familiar to all who were watching
the market in the late 1990s into the year 2000.

For Dow Theorists, the primary trend bear market, or “panic” as was
still the accepted terminology in Charles Dow’s day, also has three stages
that mirror the three stages of the primary bull market.

Stage 1: Distribution. This is the point where the “smart money” starts
to move out of stocks; but the majority of investors are still willing
buyers because they feel that the market still has a long way to go on
the upside. The market, however, starts to look tired.

Stage 2: General decline. This downward trend is characterized by deteriorating
business conditions, falling revenues, and shrinking profits.

Stage 3: Despair. At this point, there is no good news around. The
economic outlook is bleak and nobody wants to be involved with
the stock market, which appears to be a loser’s game. There is
a generally pervasive lack of confidence in the future. The despair
stage continues until all of the bad news is fully priced into
stocks, then the cycle can begin again. It is at this stage that financial
reporting may adopt a very negative tone on the prospects
for the market. The most often quoted example of this is the
Business Week cover story of August 13, 1979, “The Death of Equities,”
which foretold the forthcoming demise of stocks as the
Dow languished at around 840, a prognosis that clearly now seems
somewhat premature with the Dow above 12,000, as of February
28, 2007.

Peaks and Troughs
Dow Theorists seek to identify the primary trend using what is known as
peak and trough analysis. An uptrend is detected by prices forming a
series of higher highs and higher lows. A downtrend is characterized by
prices setting a series of lower highs and lower lows. Additionally, it is also
an important part of the theory that the Dow Jones Industrial Average and
the Dow Jones Transportation Average both confirm the trend. Until 1897,
there had been just one stock average maintained by Dow Jones & Co., but
at the beginning of that year separate averages were established for railroad
and industrial stocks. Today’s equivalent of the early Rail Average is

the Dow Jones Transportation Average. It is normally to be expected that
the Transportations lead the confirmation of any trend, as stocks in that
index are especially cyclical and, by definition, highly susceptible to economic
changes. However, Dow Theory holds that the certainty of a new
trend can only be considered to have been firmly established when both
averages confirm each other’s evidence of it.

Trading volume is also said to provide additional evidence of which
trends are in place. “A market which has been overbought,” according
to Rhea, “becomes dull on rallies and develops actively on declines; conversely,
when a market is oversold, the tendency is to become dull on declines
and active on rallies. Both markets terminate in a period of excessive
activity and begin with comparatively light transactions.”

As previously mentioned, the Dow Theorists in no sense shy away
from looking at what they are trying to achieve as “speculation.” However,
they look rather askance at short-term speculation/trading. Rhea voices the
rather low level of importance he places on the ripples in his Story of the
Averages, asserting that the study of the ripple fluctuation, or the minor
trend as it is also termed, warrants only 10 percent of serious study time.8
As Dow Theorists see it, the study of ripple fluctuations provides little predictive
information from the price data to point to the trends that truly
interest them, the primary bull and bear trends.

For Dow Theorists, the principal reason that there should be any examination
of short-term fluctuations is to ascertain whether these start
to form patterns over time, which may be valuable in helping to identify
the more important primary and/or secondary trend. One of the patterns
that may be formed by ripple fluctuation movements is a so-called “line.”
Hamilton many times referred to “lines,” which were really trading ranges
where the market moves sideways for two to three weeks or longer. According
to Dow Theory, such trading ranges indicate either accumulation
or distribution, but which one it actually is will only become apparent once
the market breaks out to the upside or downside.

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