If you watch any business channels like CNBC, ET Now etc. or read financial newspapers; I am sure you would have stumbled upon stock market analysts discussing about which stock is going to skyrocket, which is going tumble and so on. If you go a level deeper, you would have heard jargons like support, resistances, momentum, and so on. I think, these analysis are addictive especially if you like numbers, ratios and charts.
Since I had burnt lot of cash and time on this in the past, I have been keeping away a bit from this. However after seeing the tenth edition of a classic book on technical analysis by Edwards and Magee; I couldn’t resist myself and have started reading it again 🙂
Dow Theory is perhaps THE fundamental concept in technical analysis. Being one of the first proponents of technical analysis, his thoughts are foundations of any other theories/models/indicators. Here is a quick overview of the tenets of Dow Theory.
- Price discounts everything. As the main proponent of technical analysis, Dow opines that all that matters in an exchange is the trend in price; every emotion, external stimuli and what not is contained in the price.
- Price moves in three trends – Primary trend that gives the sense of direct (bull v/s bear markets), Intermediate trends that drive the primary trend and finally minor trends which can fluctuate either ways. It is considered that all some can try to lobby is the minor trends; but its very hard to influence primary trends.
- Averages must confirm. Originally, Dow had created two averages – industrial average constituting representative industries and secondly, transportation average constituting the average of other stocks. As per the theory,both should follow the same trend. Because they reflect the combined market activities of rookies, and professionals, the Averages has the capability to discount.
- Volume of trading must confirm with the trend. High volume indicates strenght in trend; low volume indicates weak strength of the trend – be it bullish or bearish.
- Trends is assumed to be in effect until a definite reversal signal is given. Trend is Your Friend in trading. Trend in motion tends to stay in motion.
- Trends usually follow three phases — accumulation, public participation and distribution. Also it depends on which primary trend the security is following.In a bull market, the first phase is of accumulation during which farsighted investors (call fundamental analysts, bankers etc.) pick up shares offered by discouraged sellers. Financial reports may be bad during this phase; so public participation will be minimal. The second phase involves a steady advance and increasing activity and better corporate results. This starts to attract more investors. Technical traders make maximum profit during this time. The final phase involve increase public participation, increased volumes and prices trending upwards. In the case of a bear market, the phases are the other way round.The first is the distribution period (started in bull market). During this phase, intelligent investors sense securities are over-priced, earnings are not good etc. though trading volumes are high, and the public is still active. The second phase is the panic phase in which buyers become lesser and lesser and sellers in panic mode. This is followed by the die out phase.
Too old; but too good?
Many professionals argue that though Dow theory is the foundation to all technical analysis, it has lost its charm. From the beginning it had opponents and with the advent of new corporate/industrial dynamics, it is argued that more sophisticated indexes and indicators are required. Having said that the concepts that Dow put forth still holds good.