Investing in Philippines: Revisiting the DOW Theory


Monday, December 27, 2010

Revisiting the DOW Theory

2011 is coming and with full optimism we look forward on having a bull run for the PSE.

Let me revisit the DOW theory as I quote some words from our very friendly (some personal explanations in parenthesis and in red)

Charles H. Dow

Six basic tenets of Dow Theory

  1. The market has three movements
    (1) The "main movement", primary movement or major trend may last from less than a year to several years. It can be bullish or bearish. (2) The "medium swing", secondary reaction or intermediate reaction may last from ten days to three months and generally retraces from 33% to 66% of the primary price change since the previous medium swing or start of the main movement. (3) The "short swing" or minor movement varies with opinion from hours to a month or more. The three movements may be simultaneous, for instance, a daily minor movement in a bearish secondary reaction in a bullish primary movement.
    (Trend can vary thus an investor or trader should look at a stock's primary trend to have an idea of the stock's general direction.Is it going up for the  past years of is it going down or has it been stagnant for 3-5 years)

  2. Market trends have three phases
    Dow Theory asserts that major market trends are composed of three phases: an accumulation phase, a public participation phase, and a distribution phase. The accumulation phase (phase 1) is a period when investors "in the know" are actively buying (selling) stock against the general opinion of the market. During this phase, the stock price does not change much because these investors are in the minority absorbing (releasing) stock that the market at large is supplying (demanding). Eventually, the market catches on to these astute investors and a rapid price change occurs (phase 2). This occurs when trend followers and other technically oriented investors participate. This phase continues until rampant speculation occurs. At this point, the astute investors begin to distribute their holdings to the market (phase 3).
    (stock trading/investment has a basic cycle that is accumulation-participation-distribution. In other terms buying at low price-holding or trading sideways-profit taking)

  3. The stock market discounts all news
    Stock prices quickly incorporate new information as soon as it becomes available. Once news is released, stock prices will change to reflect this new information. On this point, Dow Theory agrees with one of the premises of the efficient market hypothesis.
    ( a stock price reflects current events in a corporation. When there is a news or rumor of upcoming dividends distribution, good Quarter reports and the likes it would likely affect the stock's price. Same as well for bad news thus bad news can pull down a stock's price when it is out in the open)

  4. Stock market averages must confirm each other
    In Dow's time, the US was a growing industrial power. The US had population centers but factories were scattered throughout the country. Factories had to ship their goods to market, usually by rail. Dow's first stock averages were an index of industrial (manufacturing) companies and rail companies. To Dow, a bull market in industrials could not occur unless the railway average rallied as well, usually first. According to this logic, if manufacturers' profits are rising, it follows that they are producing more. If they produce more, then they have to ship more goods to consumers. Hence, if an investor is looking for signs of health in manufacturers, he or she should look at the performance of the companies that ship the output of them to market, the railroads. The two averages should be moving in the same direction. When the performance of the averages diverge, it is a warning that change is in the air.
    Both Barron's Magazine and the Wall Street Journal still publish the daily performance of the Dow Jones Transportation Index in chart form. The index contains major railroads, shipping companies, and air freight carriers in the US.
    (this is the concept of stock index and understanding the correlation of indexes. Also it tells us about the correlation of a major stock market like the Dow to the PSE thus we have the joke "Bumahing lang ang Dow trangkaso na sa PSE")

  5. Trends are confirmed by volume
    Dow believed that volume confirmed price trends. When prices move on low volume, there could be many different explanations why. An overly aggressive seller could be present for example. But when price movements are accompanied by high volume, Dow believed this represented the "true" market view. If many participants are active in a particular security, and the price moves significantly in one direction, Dow maintained that this was the direction in which the market anticipated continued movement. To him, it was a signal that a trend is developing.
    (a stock's price increase should be validated with an increase  of volume. If the stock's price surge without a confirmation of a higher volume it could mean so many things or it could also mean that the stock is being played by the jockeys)

  6. Trends exist until definitive signals prove that they have ended
    Dow believed that trends existed despite "market noise". Markets might temporarily move in the direction opposite to the trend, but they will soon resume the prior move. The trend should be given the benefit of the doubt during these reversals. Determining whether a reversal is the start of a new trend or a temporary movement in the current trend is not easy. Dow Theorists often disagree in this determination. Technical analysis tools attempt to clarify this but they can be interpreted differently by different investors.
    (a stock's trend  may be different from the rest but soon it will follow the general trend with the help of indicators one can predict if the stock is following the trend or if it has shifted to another trend thus ending the current trend)

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