The birth of technical analysis, at least in the Western world, was with Charles Dow in New York at the end of the 19th century. Dow joined with Edward Jones in publishing an afternoon newsletter to the banks and brokerages on Wall Street. Dow and Jones are remembered in the name of the US Index, the Dow Jones Industrial Average, and in other indices, and the afternoon newsletter became the Wall Street Journal, still published today.
Dow became fascinated by the markets, and wrote many articles about them in the newsletter. In 1884 he invented a gauge of the health of the economy by putting together an average of 11 stock values, including nine railroad shares. Twelve years later, in 1896, he decided that industrial stocks and transportation stocks should be separated, and so the Dow Jones Industrial Average (DJIA) and the Dow Jones Transportation Average (DJTA) were born. The industrial average started with 12 stocks and now contains 30. The transportation average had 20 railroad stocks.
The reason Dow split the indices was that he was a student of the interaction between industrial and transportation companies. He wanted to have a gauge of the health of each sector. Most of the time Dow dealt only with the averages and not necessarily with individual shares in developing his concepts. He maintained that both transportation and industrial sectors had to be in sync to provide a true reflection of the state of the economy. “What one makes, the other takes,” was one of his maxims, which meant that if industry was doing well, then transportation must also be increasing to deal with taking the goods to market. If one was doing well and the other wasn’t, then he suspected that some transient effect on the stock market had caused the problem, and any apparent boom should be distrusted.
It was Dow who first noted in print the tendency of shares at prices to move in trends for much of the time. He identified the three basic trends, an uptrend, a downtrend, and a line, which is what he called a price fluctuating around the same value, sometimes called trading sideways. He also noted that in many trends there are short setbacks, or secondary trends, which run counter to the original direction, and that trends tend to continue in the same direction until something acts to stop them.
Uptrend and downtrends are fairly clear, with the requirement that you get higher and higher price points in an uptrend, and lower and lower price points in a downtrend – we’ll look at that in more detail later. Dow defined the line as a price that fluctuated by no more than 4%, but usually analysts don’t put that restriction it nowadays. After all, it depends how volatile the stock is how much it will vary while staying around the same level. Possibly Dow imposed this rule because he was considering mainly indices, where the volatilities are averaged out.
If you have been looking at trading, you may have heard of the Dow Theory. I hate to disappoint you, but Dow never composed a theory as such. This was put together after his death from his editorials in the Wall Street Journal. Various authors have taken it at different times and elaborated on the ideas. Dow himself never thought of his ideas as a way to trade the stock market, but merely as a commentary on the general economic health of the markets. Nonetheless, the principles that Dow put forward are still considered valid.
The six principles that are generally agreed to form the Dow Theory, which were taken from his essays, are as follows: –
- the averages reflect everything that can be known about the price,
- the markets exhibit 3 types of movement, primary, secondary and minor,
- primary movements have three phases,
- it takes both the industrial average and transportation average to confirm a trend,
- a valid trend should have volume increasing in the direction of the trend, and
- the trend will continue until there is a clear reversal.
Going through each of these in turn, the first one should be familiar as it restates the first principle technical analysis, though it talks about averages because that was Dow’s interest.
Dow classified the movements of the market into three types, based on how long each movement lasted. The primary movement lasted for a year or more, the secondary which was a counter move to the primary, called a retracement, from three weeks to three months, and the minor was basically a fluctuation less than three weeks long. These are simply observations that he had made of the market.
Dow divided the ups and downs of the market up into three stages, and the idea of splitting price movements into phases is a precursor to the Elliott Wave Theory which came later, and will be described in a later chapter. It is convenient to view charts in sections, as they can show some repeatable patterns. This idea is also explored in the next principle, of primary movements having three phases, and it is useful to see how these are formed.
Dow showed remarkable insight in describing the mood of traders and investors to illustrate the third principle. The three phases that make up a primary movement are based on human psychology, which, as we confessed earlier, doesn’t change. Consider for example and uptrending market, where the prices are increasing fairly steadily. The very first part of the trend is called an accumulation phase, and it denotes where only the best informed investors have decided that the stock is a good buy. When word of this gets around, perhaps by others observing the increasing prices, everyone jumps on board, many more buyers are involved and this is called the public participation phase.
However, the way people are means that they keep piling in on the stock, more in hope than for good reasons, speculating that the rise will continue forever. At this stage, the first people in, the best informed investors, quietly exit without being noticed and take their profits. The trend hasn’t finished, but the end is in sight. This is called the distribution phase.
Is not always easy to tell what phase a trend is in – just looking at the chart doesn’t help, because if it did no one will be left holding the stock when the trend finished and the price reversed. Technical analysis helps in understanding the mood of the market, as you will find out.
As you might expect, the chief of the trend is the public participation phase, when most people get involved. It would be great if you could always anticipate the accumulation phase, as then you would stand to make the most profit. Even so, if you get in on the public participation phase then you still profit, provided you get out before the distribution phase comes to an end. If you only jump in when the distribution phase is started, then there is not much going to be had and you are vulnerable to losing.
The other three Dow principles we have touched on before. The fourth one, requiring both transportation and industrial averages to be tending the same direction so that they can be considered valid, is relevant in overall terms although not applicable to trading any individual stock. The fifth, requiring volume to increase to confirm a trend is in some ways obvious, but can easily be forgotten. If people aren’t buying into a stock, then any increase in price may not be valid, and not in accordance with the general feeling. And the sixth is another fundamental of technical analysis, that trends will continue unless something happens to reverse them. There is an opposite view to this that still has some advocates even though it has been disproved in practice and in theory, and we’ll talk about that later.
So what problems might there be with the Dow Theory? Can we still rely on those six principles to help with our trading? One point is that Dow only used a simple line chart such as you’ve already seen, and you can learn a whole lot more with more complex charts as you will find out in the next chapters. Dow adopted a safe position, only identifying a trend when it was in force, and as you will see, we have tools in technical analysis that try to find the trends early. Also, he only dealt with averages and wasn’t really into individual stocks. His view was longer term than the typical short-term trader, so although his principles make good sense they aren’t always applicable to what we want to do.
The real lesson I would like you to learn from Dow’s work is that he looked at what the markets were doing, and then based his ideas on his observations. He did not mess around with thinking about what the markets should be doing, how they should react to any news, or any of that stuff. He learned from the markets, and allowed them to tell him what was happening. Many a novice trader thinks they know better, and can anticipate what prices should do, and has been caught out by their power of reasoning.