If you are even remotely interested in technical analysis or “charting”, you should be familiar with the six tenets of Dow theory. They are:
The markets have three trends.
- Up trends: when highs occur at levels higher than previous highs and when lows occur at levels higher than previous lows.
- Down trends: when a market makes lower lows and lower highs.
- Correction: a sharp move in the opposite direction of the general trend before then continuing with the overall trend.
Trends have three phases.
- Accumulation phase: expert traders are actively taking positions, which is against the majority of traders. During this time, stock prices shouldn’t change too much because the expert investors are taking the minority position – either buying when everyone else is selling or selling when everyone else is buying.
- The public participation phase: the public begins doing what the experts have already done and trade in the same direction. Once this catches on, a rapid price change occurs and it is too late to “get in at the bottom”.
- Excess phase: rampant speculation comes in and experts begin exiting their trades.
The market discounts everything.
Once news is released it is already reflected in the market price. If this is true, then fundamental analysis shouldn’t work. Anyone who knows me knows that I don’t believe that the market is 100% efficient, but understanding that it’s efficient most of the time will help a great deal. Because stock prices should quickly incorporate new information as soon as it’s available, you shouldn’t think that financial news or media gives you an edge.
Averages must confirm each other. This isn’t as relevant in today’s time, but what Dow was saying was that the Dow Jones Industrial Average and the Dow Jones Transportation average should be positively correlated. If they are correlated then it serves as a confirmation of a trend. You should be more confident if the Dow/S&P/NASDAQ all move in the same direction.
Trends must be confirmed by volume. Technical analysts definitely pay attention to volume because if a price rises or falls with large volume, it indicates that there are a lot of participants in the market so it is evidence that a trend is taking place. Dow believed that if price movements were accompanied by high volume, they represented the true market view and the high volume acted as a signal that a trend was developing.
Trends exist until definitive signals prove they’ve ended. Despite what you may hear on the news, trends still go on. Many investors were shocked to see that the market didn’t plummet after JFK’s assassination. Sure, markets might temporarily move in an opposite direction, but soon enough they should resume their overall trend. However, be warned that it isn’t easy to tell whether or not a trend has ended.
This is just scratching the surface. Are any of my readers trend followers or at least give much weight to market trends? Is “the trend your friend”? Let me know in the comments below!