I’d like to return to my original assumptions, that using the basic tenets of Dow Theory is one building block on which other investment theories and strategies can be built upon. While imperfect on its own, one must pour the concrete before you build the walls, and certainly long before you pick out the window dressings. The rules of Dow Theory are part of that concrete mix for the foundation of your investment house.
Let’s readdress the rules set forth by Rhea, Russell and others.
- The Averages Discount EVERYTHING. This is called the Efficient Market Hypothesis. The closing prices of the two indexes give us a complete index of everything known by anybody than can possibly affect the economy and corporate profits.
- The market consists of three movements which operate simultaneously. Primary (one to many years), Secondary, (one to three months) and Daily. Daily movements are ultimately irrelevant, except for over time producing primary and secondary trends, but gain the most attention by the general public.
- A primary bull is a broad upward movement interrupted by frequent secondary reactions. These have three phases where the first is a return to normal values, the second is caused by bettering business conditions and is usually the longest, and the third is feverish and speculative.
- A primary bear is a broad downward movement which serves to correct the excesses of the previous bull markets speculative phases and does not end until the worst that may happen, has.
- Successive rallies and declines must advance or decline past previous points. For example, in a bull market the next high and low of the secondary movements within the primary must be higher than the previous high and low. Of course the opposite is true for a declining market.
- The movements of the two averages must confirm each other. The logic is that if there is to be a valid increase in manufacturing and production, there will also be an accompanying increase in shipping and transportation.
- Volume expands in the main direction of the trend.
- “Lines” form when both averages remain within an area of about 5% for 2 weeks or longer, indicating a period of very evenly matched buying or selling. Both averages penetrating their line limits can predict higher or lower prices to come.
- The word “penetration,” under Dow Theory, implies any movement through a given point of one cent or more. Some scholars demand a one dollar move as a more valid signal.
- Finally, and most importantly, the primary and secondary movements are NOT susceptible to manipulation.