The Dow Theory
"We see the same patterns occur over and over again!"
-------------------------------------------------------------------------------
--------------------------------------------------
We see the same patterns over and over again!
That's the common pronouncement from technical analysts. And technical analysis (as distinguished from fundamental analysis) is the foundation of Dow Theory.
---------------------------------------------
Many factors go into determining market prices, but the bottom line for the chartist is the price at which buyer and seller get together for a trade. "This is the only figure that counts," say the technicians.
The argument is that all relevant factors are in the price behavior. The price patterns alone reveal the state of mind of traders. For example, charts can tell you when smart money is accumulating stocks and when the uninformed are buying.
It follows that the future is in the charts! Not the stars but the unfolding patterns of price form the basis for predicting what will happen next. The charts and the time series they project thus become the working tools of the technical analyst. It is also the basis for the Dow theory.
-----------------------------------------------
Volume is another important factor of charts. According to Edwards and McGee, volume is a vital part of the picture and itself forms patterns, just as the price component does.
The two go together and each must conform to the requirements of the case. But note also that volume is relative. When we speak of high volume, we mean a rate of trading notably greater than has been customary in that particular stock during the previous period under examination.
---------------------------------------------
The significance of charts for the Dow Theory is that prices can form topping and bottoming patterns (distribution and accumulation patterns), like head and shoulders tops and inverse head and shoulder bottoms.
The formations can occur for market averages as well as for individual stocks. It's this fact that uniquely identifies Dow Theory. The theory uses the Dow 30 Industrials average and the Dow Transportation average as the basis for its judgments, and it draws its conclusion from their joint performance.
The key is this: If the Dow 30 comes off a recent high in a bull market and drops below the last previous low, and the Transportation average does the same thing with its own new low, then the market is said to have entered a major bear phase.
Say for example, the Dow forms a head & shoulders pattern and breaks down from it, meaning the price drops below its "neckline," and the transportation average follows by doing the same thing. This confirms a new, bearish trend. (Edwards and McGee, and others, give many examples of many different price patterns.)
The order isn't relevant. The Transportation index could be first to go. This was the situation in a recent market, because the Dow 30 confirmed an earlier Transportation low, according to the Dow theorists.
-----------------------------------------