Use Dow Theory To Adjust Your Stock Market Risk

In this age of digital trading and the constant 24 hour news cycle, many stock market analysts dismiss Dow Theory as an archaic stock market gauge.  In my view, you they dismiss Dow Theory at their peril.

Keep this in mind though…Dow Theory is not a market timing tool.  It is simply a tool for gauging the current health of the market.

Your goal for using Dow Theory should simply be to improve the risk adjusted returns in your portfolio.

What Is Dow Theory?

There are basically four phases of the market…

1) The market is bullish and rising

2) The market is correcting within a bull market

3) The market is bearish and falling

4) The market is correcting within a bear market

Market participants are always at odds as to which is the current phase of the market.

Dow Theory is an approach to monitoring the stock market derived from the Wall Street Journal editorials written by Charles Dow.

Dow was a journalist and the first editor of the Wall Street Journal and co-founder of Dow Jones and Company.  Dow himself never used the term “Dow Theory” nor presented it as a trading system.

The Six Basic Principles of Dow Theory

According to the Certified Market Technicians Association, Dow Theory has six basic principles…

First, the market has three movements

  • The primary trend may last from just under a year to several years or more and it can be bullish or bearish
  • The medium swing or intermediate reaction may last from a couple weeks to several months or more
  • The short swing may last from several days to a month

Two, major market trends have three phases

1) The accumulation phase where professional investors are actively buying or selling stock against the general opinion of the market.  During this phase the price of the market does not change much because these investors are in the minority

2) In the second phase, the public catches on and a rapid price change occurs in the market. This phase will continue until rampant speculation occurs

3) The astute investors begin to distribute their positions to the market.

Three, the market DISCOUNTS all news. 

Stock prices quickly incorporate new information as it becomes available.  Once news is released the market changes in price to reflect the new information.

Four, the stock market averages must confirm each other

In Dow’s day, this meant that industrial stocks must move in the same general direction as the railroad stocks, which moved the goods produced by the industrial companies.  To Dow, a bull market in the industrials could not occur unless there was a bull market in the rails.

If manufacturing profits are rising it follows they are producing more.  If they are producing more, it follows that they must ship more goods.  Therefore, to understand the health of the industrials, look to the rails.

The two averages should then be moving in the same direction.  When they diverge, it is a warning sign.

Currently, the Dow Jones Industrials are made up of a different mix of businesses that reflect the overall economy.  In addition to manufacturing businesses are financial services, technology, consumer staples and energy companies.

Meanwhile, the Dow Transports consist of railroad, airline and trucking stocks.

Five, Volume must confirm the trend

Dow recognized volume as a secondary but important factor in confirming price signals.

Simply stated, volume should expand or increase in the direction of the major trend. In a major uptrend, volume would then increase as price move higher, and diminish as prices fall. In a downtrend, volume should increase as prices drop and diminish as they rally.

While based his actual buy and sell signals entirely on closing prices, today’s sophisticated volume indicators help determine whether volume is increasing or falling off.  Experienced traders then compare this information to price action to see if the two are confirming each other.

Six,  Trend Is Assumed to Be in Effect Until It Gives Definite Signals That It Has Reversed

In general, a trend in motion tends to stay in motion.  But, how do you define when the trend has ended?

Traders who employ trend following approaches to their trading may use a simple indicator such as a 200 day moving average to define a trend.  If price is above the 200 day moving average and the slope of the average is up, then the trend is up, and vice versa if the trend is down.

The bottom line is that there is no way to definitively state when the existing trend has ended.  This is why most traders simply use trading rules to enter and exit positions.

Dow Theory in Practice – Recent History

While many stock market analysts discount Dow Theory as antiquated, it clearly has provided signals of danger ahead of the two most recent bear markets, as well as the stock market correction that occurred from 2015 to early 2016.

For instance, in 1999, the Dow Transports peaked in May, and the Industrials continued to rise until peaking in January 2000.

Dow Theory

After peaking in May 1999, the Transports entered a clear downtrend, and by August, it had broken through its 200 day moving average.  The average then turned down later that month.  Meanwhile, the Industrials continued higher, and actually set a new all time high in early 2000.

While the Dow continued to trade in a trading range for the next 18 months, there was significant carnage in the Nasdaq Composite, which crashed over 30% from its March 2000 high within the next two months.

In 2007, both averages peaked in July.  The Transports began a correction, while the Dow made a second peak in October, and then began its decline.  The Transports then found a bottom and rallied into May 2008.

Dow Theory

This rally was not confirmed by the Dow Industrials, and both began breaking down in June 2008, and ultimately plunged in the Fall of that year through March 2009.

In 2015, the Dow Industrials corrected as much as 14% from its high price in May.  The Transports actually peaked in December 2014 and started breaking down more sharply in May.

Dow Theory

It is noted that the Industrials were trading in a narrow range and failing to make upside progress as the Transports were declining.  This is in line with the Dow Tenet that the professionals are selling before the general market catches on.

Final Thoughts

The Dow Theory is really a simple way of monitoring the economy and the stock market.  When an investor spots a divergence between the two averages, it is time to be less aggressive with any upcoming stock trades or investments.

The reason is that during a bear market, at least two out of three stocks will follow the direction of the market, and there will be more false breakouts, even among the market leaders.

In fact, it’s a good idea to pay attention to the price action of the market leaders.  Traders and investors will sell their winners in an effort to make up for losses in other areas of their portfolio and to raise money to meet margin calls.  Market leaders will roll over sharply when this occurs.

By | 2017-12-11T22:39:15+00:00 December 12th, 2017|Categories: General, Stock Market|Tags: , |0 Comments

About the Author:

Scott Cole is a commercial real estate appraiser, licensed realtor, former commodity trading advisor and commodity futures broker, golf instructor and 1st degree black belt in Pai Lum Kung Fu. He is an entrepreneur just hoping to make a difference.

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