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. In part 2 we explained how to identify Dow Theory movements. This post will focus on the trend of the market and possible changes in the trend.
In order to identify a long term trend, confirm a trend, or warn of a possible change in trend Dow Theory requires the use of closing prices for both the Dow Jones Industrial Average (DJIA) and the Dow Jones Transportation Average (DJTA). Both averages must move together in the same direction to provide confirmation of a trend. When the movement of the two averages conflict they warn of a possible change in trend.
When the market is in a primary bullish trend both DJIA and DJTA move together to consistently make higher closing highs and higher closing lows. Dow Theory calls the higher highs Secondary High Points. It names the lows as Secondary Low Points. Conversely, a primary bear market sees both averages moving together making as series lower secondary lows and lower secondary highs. If you have properly identified the secondary high and low points it is easy to spot a confirmed trend in the market. Remember, most of the bad information you see about Dow Theory comes from people mislabeling secondary highs and lows. On the chart below the green lines represent a confirmation of an uptrend where price of both indexes surpassed a previous secondary high point.
One thing to note is that Dow Theory allows for the confirmation of an intermediate trend that may not be confirmed by the longer term trend. William Peter Hamilton explains it thus:
When a series of rallies…carry above immediately preceding high points, with declines failing to penetrate recent lows, the implication is bullish for the immediate future, but not necessarily indicating a primary bull trend.
An example of this is during the period between late 2011 and early 2013. In late 2011 both averages confirmed an uptrend in the near term, but DJTA failed to confirm the longer term trend when DJIA did in early 2012 (near the yellow line in the chart above). Confirmation of a primary bull market did not occur until early 2013 when DJTA finally made it above its long term secondary high.
A warning of a possible trend change from bullish to bearish occurs when one average moves to a higher high and the other average stalls. This does not mean the trend will change, only that the possibility of a change exists. An example can be seen on the chart above. The yellow line shows a point where DJIA continued to move higher while DJTA was moving lower. DJIA went on to make two small higher highs while DJTA was making lower highs. This provided warning of a possible change in trend.
The most widely known (and least understood) aspect of Dow Theory is a confirmation of a primary trend change. Robert Rhea explains trend changes as follows:
When declines in a primary bull market result in violating the lowest points encountered during the last major secondary reaction of that market, it may generally be assumed that the primary trend has changed from bullish to bearish; the converse, of course, is usually a dependable means of determining when a bear market primary trend has changed to the beginning of a bull market.
Many commentators refer to a primary trend change as a “buy signal” or a “sell signal”. Dow Theory has no such signals. Instead, it uses the primary trend, warnings of trend changes, and secondary reactions to make adjustments to a portfolio of stocks. In our next post in this series we’ll explain how to use Dow Theory for portfolio allocations.