When the Dow Jones Industrial Average (DJIA) is making new highs and the Dow Jones Transportation Average (DJTA) follows to new highs as well you often seen news reports exclaiming a “Dow Theory Buy Signal”. If you use those reports to make investment decisions you’re being misled by a writer who doesn’t understand Dow Theory. There are no buy signals or sell signals in Dow Theory that indicate a specific date where you should go long or short. Robert Rhea in his book “The Dow Theory” went so far as to warn about buying or selling just after a confirmation of a trend change due to the risk of an abrupt correction near those points.
Whenever prices have pushed through into new low ground in bear markets or to new highs in bull markets, it is usually safe to assume the primary direction will be maintained for a considerable time; but every trader should remember that from such new peaks or valleys secondary reactions can occur with amazing rapidity. (emphasis mine)
Instead of buying or selling the point where both DJIA and DJTA confirm the trend with new high or low points, Dow Theory technicians recommend making changes to a portfolio based on the prevailing trend, secondary reactions, and warnings of the change in trend. They suggest that an investor should identify the current trend and trade with it by using the secondary reactions as a place to make portfolio adjustments. For example, in a primary bull market an investor should wait patiently for a correction (secondary reaction) that lasts from three weeks to three months and retraces 33% to 66% of the previous rally before allocating more money on the long side. When a rally in a bull market gets extended Dow Theory technicians take profit. They don’t attempt to short the market during a confirmed bullish trend. Robert Rhea explains it thus:
When a quiet but firm market develops activity and strength on the upside, it may be bought with the intention of closing out commitments either while strength and activity is still increasing or when the market refuses to advance further on an increasing volume of transactions. However, the speculator who goes short in a bull market is merely guessing at secondary reactions and the odds are heavily against his cashing profits on such sales. It would be far better for him, after taking profits on a rally, to stand on the sidelines during the decline and await the inevitable dull period after a recession in a bull market before again making commitments.
It is a uniform characteristic of secondary reactions in bull markets that the extreme low point of the reaction is generally accompanied by fairly heavy volume. Then the market usually advances for a day or two on uniform or slightly declining volume, followed by a further decline which fails to penetrate the recent lows, and if the volume diminishes perceptibly on this decline, it is reasonable to assume that the secondary reaction has run its course and that the primary bull trend is apt to be resumed, provided the secondary reaction can be assumed to have run its course, which should be somewhere 33 percent and 66 percent of the total primary advance attained since the last preceding important secondary reaction.
Conversely in bear markets, both William Peter Hamilton and Robert Rhea advised traders to short rallies when volume started to dry up. The time to cover those short positions was after a decline that continues the primary bear trend, had a sharp fall in price, and heavy volume. Traders today would call this point in a sell off capitulation.
When the trend is uncertain a trader should; reduce position size, wait, or start to accumulate positions against the prevailing trend.
Any person who tries to be in the market at all times is almost certain to lose money, for there are many times when the most skillful trader is in doubt as to what will happen. A good market axiom is ‘When in doubt, do nothing.’
Rhea advised using volume as a guide when placing trades in an uncertain market:
A market which has been overbought becomes dull on rallies and develops activity on declines; conversely, when a market is oversold, the tendency is to become dull on declines and active on rallies.
If you’ve read all the posts in this series you’ll see that Dow Theory isn’t about buy and sell signals. In fact, market technicians new to Dow Theory will quickly see that it is the fundamental basis of technical analysis today. In short, use price and volume to help determine low risk/reward trades.
Implementing Dow Theory consists of aligning your portfolio and trades with the prevailing trend and making adjustments when the market gets extended or warns of a possible change in trend. By using Dow Theory as a guide to buy dips in bull markets and sell rallies in bear markets, Robert Rhea believed that a trader could have successful trades 70% of the time, with the winners gaining much more than the losers lose…a record most active traders would envy.