In part 1 of our Dow Theory primer we explained that Dow Theory is a study of stock market price and volume that attempts to identify the prevailing trend of the market and warn of possible changes in that trend. The theory uses the movement of price of the Dow Jones Industrial Average (DJIA) and the Dow Jones Transportation Average (DJTA) with their associated volume to identify major trends. This post will focus on the movements and how to identify them.
Dow Theory Movements
Dow Theory recognizes three movements in the price of DJIA and DJTA. Those movements are: 1) Daily Fluctuations, 2) Secondary Reactions, and 3) Primary Trends.
Daily Fluctuations are the smallest duration moves in price and are irrelevant unless combined with other elements of the theory such as secondary reactions or lines. An investor looking at the day to day movement in price does not have enough information to determine the probable future direction of the market. Daily fluctuations are easy to spot. They are one day price moves. The theory generally ignores movements in price that last less than 15 to 20 days. William Peter Hamilton mentions 20 days while Robert Rhea uses 3 weeks as a criteria for identifying the next larger movement of Secondary Reactions.
Secondary Reactions are substantial moves in price against a longer term trend. Here are the characteristics of the moves that identify secondary reactions. Please note that these are general guidelines and not specific filter criteria.
- A counter move that lasts from 3 weeks to 3 months (i.e. a correction after a longer term rally)
- A retracement from another secondary reaction generally between 33% to 66% (see the correction that started in late October 2011 in the chart below for an example)
- A retracement that is shorter in duration than the move it is retracing
- A retracement that is more steep than the move it is retracing (i.e. a steep downward move after a long grinding rally)
- Secondary Highs are marked with low volume before the high
- Secondary Lows are marked by heavy volume at the low
Most of the confusion and bad interpretation of Dow Theory comes from misidentifying secondary highs and secondary lows. When you annotate your own charts be sure to use the rules above to be more certain of your secondary reactions. The chart below shows some examples of secondary highs and lows during a rally. Notice the duration, size, and slope of each rally against their counter move.
Primary Trends are the longer term movements in the market that encompass many secondary reactions. Most people refer to primary trends as bull or bear markets. Here are the identifying characteristics of bull and bear markets.
- A move that lasts from about 1 year to several years
- A longer term move that has several substantial counter moves (Secondary Reactions) that do not break the previous counter move (i.e. A bull market has successive higher lows)
- A move that continues to confirm the trend (i.e. A bull market has successive higher highs)
- A move where the duration in primary direction lasts longer than the secondary reactions (i.e. A bull market that grinds higher for several months then has a correction that lasts only several weeks)
- Bull markets are generally longer than bear markets
- Bull markets generally have higher volume than bear markets
See the chart above for an example of a bull market. Notice the succession of higher highs and higher lows. The guidelines above explain how to identify the primary trend. Our next post in this series will go into detail about trends and explain how to identify possible changes in the primary trend.