rials had thus far not confirmed the Rails incontinuing the downtrend — but this had to do only with the continuation or reaffirmation of an existing trend. It is not necessary thatthe two Averages confirm on the same day. Frequently, both willmove into new high (or low) ground together, but there are plentyof cases in which one or the other lags behind for days, weeks, oreven a month or two. One must be patient in these doubtful casesand wait until the market declares itself in definite fashion.9. “Volume Goes with the Trend” — Those words, which you mayoften hear spoken with ritual solemnity but little understanding, arethe colloquial expression for the general truth that trading activitytends to expand as prices move in the direction of the prevailingPrimary Trend. Thus, in a Bull Market, volume increases when pricesrise and dwindles as prices decline; in Bear Markets, turnover increases when prices drop and dries up as they recover. To a lesserdegree, this holds for Secondary Trends also, especially in the earlystages of an extended Secondary Recovery within a Bear Market,when activity may show a tendency to pick up on the Minor Ralliesand diminish on the Minor Set-backs. But to this rule, again, thereare exceptions, and useful conclusions can seldom be drawn fromthe volume manifestations of a few days, much less a single tradingsession; it is only the overall and relative volume trend over a periodof time that may produce helpful indications. Moreover, in DowTheory, conclusive signals as to the market’s trend are produced inthe final analysis only by price movement. Volume simply affordscollateral evidence which may aid interpretation of otherwise doubtful situations. (We shall have much more to say in later chaptersabout volume in specific relation to other technical phenomena.)10. “Lines” May Substitute for Secondaries — A Line in Dow Theoryparlance is a sideways movement (as it appears on the charts) in oneor both of the Averages, which lasts for 2 or 3 weeks or, sometimes,for as many months, in the course of which prices fluctuate withina range of approximately 5% or less (of their mean figure). Theformation of a Line signifies that pressure of buying and selling ismore or less in balance. Eventually, of course, either the offeringswithin that price range are exhausted and those who want to buystocks have to raise their bids to induce owners to sell, or else thosewho are eager to sell at the “Line” price range find that buyers havevanished and that, in consequence, they must cut their prices in orderto dispose of their shares. Hence, an advance in prices through theupper limits of an established Line is a Bullish Signal and, conversely,
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Technical Analysis of Stock Trendsa break down through its lower limits is a Bearish Signal. Generallyspeaking, the longer the Line (in duration) and the narrower or morecompact its price range, the greater the significance of its ultimatebreakout.Lines occur often enough to make their recognition essential tofollowers of Dow’s principles. They may develop at important Topsor Bottoms, signaling periods of distribution or of accumulation,respectively, but they come more frequently as interludes of rest orConsolidation in the progress of established Major Trends. Underthose circumstances, they take the place of normal Secondary Waves.A Line may develop in one Average while the other is going througha typical Secondary Reaction. It is worth noting that a price movement out of a Line, either up or down, is usually followed by a moreextensive additional move in the same direction than can be countedon to follow the “signal” produced when a new wave pushes beyondthe limits set by a preceding Primary Wave. The direction in whichprices will break out of a Line cannot be determined in advance ofthe actual movement. The 5% limit ordinarily assigned to a Line isarbitrarily based on experience; there have been a few slightly widersideways movements which, by virtue of their compactness and welldefined boundaries, could be construed as true Lines. (Further on inthis book, we shall see that the Dow Line is, in many respects, similarto the more strictly defined patterns known as Rectangles whichappear on the charts of individual stocks.)11. Only Closing Prices Used — Dow Theory pays no attention to anyextreme highs or lows which may be registered during a day andbefore the market closes, but takes into account only the closingfigures, i.e., the average of the day’s final sale prices for the component issues. We have discussed the psychological importance of theend-of-day prices under the subject of chart construction and neednot deal with it further here, except to say that this is another Dowrule which has stood the test of time. It works thus: suppose anIntermediate Advance in a Primary Uptrend reaches its peak on acertain day at 11 a.m., at which hour the Industrial Average figuresat, say, 152.45, and then falls back to close at 150.70. All that the nextadvance will have to do in order to indicate that the Primary Trendis still up is register a daily close above 150.70. The previous intradayhigh of 152.45 does not count. Conversely, using the same figures forour first advance, if the next upswing carries prices to an intradayhigh at, say, 152.60, but fails to register a closing price above 150.70,the continuation of the Primary Bull Trend is still in doubt.In recent years, differences of opinion have arisen among marketstudents as to the extent to which an Average should push beyonda previous limit (Top or Bottom figure) in order to signal (or confirmor reaffirm, as the case may be) a market trend. Dow and Hamiltonevidently regarded any penetration, even as little as 0.01, in closing
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price as a valid signal, but some modern commentators have requiredpenetration by a full point (1.00). We think that the original view hasthe best of the argument, that the record shows little or nothing inpractical results to favor any of the proposed modifications. Oneincident in June of 1946, to which we shall refer in the followingchapter, shows a decided advantage for the orthodox “any-penetration-whatever” rule.12. A Trend Should Be Assumed to Continue in Effect Until Such Timeas Its Reversal Has Been Definitely Signaled — This Dow Theorytenet is one which, perhaps more than any other, has evoked criticism. Yet, when correctly understood, it, like all the others we haveenumerated, stands up under practical test. What it states is really aprobability. It is a warning against changing one’s market position toosoon, against “jumping the gun.” It does not imply that one shoulddelay action by one unnecessary minute once a signal of change intrend has appeared. But it expresses the experience that the odds arein favor of the man who waits until he is sure, and against the otherfellow who buys (or sells) prematurely. These odds cannot be statedin mathematical language such as 2–1 or 3–1; as a matter of fact, theyare constantly changing. Bull Markets do not climb forever and BearMarkets always reach a Bottom sooner or later. When a new PrimaryTrend is first definitely signaled by the action of the two Averages,the odds that it will be continued, despite any near-term reactions orinterruptions, are at their greatest. But as this Primary Trend carrieson, the odds in favor of its further extension grow smaller. Thus, eachsuccessive reaffirmation of a Bull Market (new Intermediate high inone average confirmed by a new Intermediate high in the other)carries relatively less weight. The incentive to buy, the prospect ofselling new purchases at a profit, is smaller after a Bull Market hasbeen in existence for several months than it was when the PrimaryUptrend was first recognized, but this twelfth Dow tenet says, “Holdyour position pending contrary orders.”A corollary to this tenet, which is not so contradictory as it mayat first seem, is: a Reversal in trend can occur any time after that trendhas been confirmed. This can be taken simply as a warning that theDow Theory investor must watch the market constantly if he has anycommitment in it.
EN: Modern Market Importance of Dow Theory andNecessity for Moving to a New Composite Market TheoryDow Theory has much to recommend it. Concepts embodied within Dow Theory retaintheir validity to the present day, and retain their importance as the foundation thinkingfor technical analysis. Concepts of waves, major secondary and minor movements areabsolutely descriptive of the reality of the market. Other constructs within Dow Theory
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are similarly important — that all information is discounted; that major market movements are like the tide and, as it were, raise all boats; that trends tend to continue.These are not just theoretical musings, but observations of reality.In addition to its technical validity the Dow has now taken on a mythicdimension. It now has a symbolic function which interacts with its originallyintended purpose. Dow and Hamilton saw their measurement of the market as aneconomic barometer for the entire economy. Its use as a tool for investing in themarket came later.In the opinion of this editor, the Dow Theory is no longer adequate to its originalpurpose — or even to its secondary purpose. It is a simple theory propounded in asimple time. Expounders of Dow Theory have implicitly recognized the necessityfor evolutionary changes to the doctrine with the addition of the Rails (now Transportations) and the Utilities ad infinitum. Thirty stocks may have been sufficientoriginally to reflect the American economy. No one would deny that simple paradigmmust be changed to reflect an economic structure geometrically more diverse thanthat of Dow and Hamilton. Entering the 21st century, the American and Globaleconomy require more sophisticated econometrics than the Dow alone.For that reason I now consider that in order to fulfill the functions of the oldDow we now must consider a variety of averages and indexes to measure the stateof the market — not to mention the economy, which is another question, althoughnot altogether another question, but at least another question. Magee foreshadowedsome instruments of great value to this end in his writings, specifically on the MageeEvaluative Index (Chapter 38), which may be used for the entire market, and notjust for one summary index or average. The value and power of this tool are stilllittle used and understood.In 21st century markets, there are not just broad tides and markets flowing inone direction as they might on Magee’s Cape Cod. Instead the currents, rip tides,and cross currents are like the economy of the country, moved West. They are nowsymbolized by the Pacific Ocean roaring in and out of San Francisco Bay. Whilethe Dow is in a secondary Downtrend, the broader S&P 500 is going to new highs,and while they are both whipping sideways, the NASDAQ is rocketing into space.For this reason, I now believe that only a composite of the three indexes can expressthe true state of the markets as a whole. And, in addition, to dissect the entrails ofthe market, the Magee Evaluative Index should be run across the three indexes.The Dow Theory required that the Rails and Industrials move in harmony in orderto signal Bull or Bear Markets. In this century, there is a similar need for harmonicconvergence among the averages to indicate to us the state of the markets as a whole.When all three indexes agree in the direction of their trends, up or down orsideways, Bulls may assumed to be safe in general, and vice versa for Bears. Failureof the three to be in harmony is a clear sign of mixed markets and advises one toarrange his bets and portfolio to correspond with economic uncertainty. Capitalshould flow naturally to the area which is most productive. What reason is there toride the Dow down when the NASDAQ is raging up? If the investor follows thephilosophy of this book, he will never sit passively through an extended Downtrend.At the very least, he will be hedged, if not outright short. (As Edwards and Mageepreferred and as this editor prefers.)
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chapter four
The Dow Theory in PracticeEN9: The casual and careless reader will shake his head at this chapter and ask whyon earth the Editor has not excised it from the book. The Editor has not deleted thechapter because, like old-fashioned cod liver oil, it is good medicine. It will appealmainly to the serious student of not just Dow Theory, but of long-term investing.If the reader has absolutely no interest in Dow Theory or long-term investing hemay skip over this chapter and return to it in his old age, when he is wiser.At this point, the reader, if he has little previous knowledge of the stockmarket, may be suffering a mild attack of mental indigestion. The DowTheory is a pretty big dose to swallow at one sitting. We departed deliberately in the foregoing chapter from the order in which its principles areusually stated in an effort to make it a little easier to follow and understand.Actually, not all of the 12 tenets we named are of equal import. The essentialrules are contained in 2, 3, 4, 5, 8, 10, and 11. Number 1 is, of course, thebasic assumption, the philosophical justification for these rules. The otherpoints (6, 7, 9, and 12) furnish “background material,” as the news reportersmight put it, which aid in interpretation. Theoretically, one should, by strictadherence to the essential rules alone, accomplish just as much as he couldwith the added collateral evidence.But the utilization of Dow Theory is, after all, a matter of interpretation.You may memorize its principles verbatim and yet be confounded when youattempt to apply them to an actual market situation. We can better organizeour knowledge of the theory and acquire some understanding of its interpretation by following through a few years of market action and seeing howit looked at the time through the eyes of a Dow theorist. For this purpose,we may well take the period from late 1941 to the beginning of 1947, sincethis covers the end of one Bear Market, an entire long Bull Market, and partof another Bear Market, and includes examples of most of the market phenomena with which the Dow Theory has to deal.
Five Years of Dow InterpretationFigure 2 is a condensed chart of the course of the two Dow Jones Averagesfrom January 1, 1941, to December 31, 1946, on which most of the MinorTrends have been disregarded but all the recognized Intermediate Swings(Primary and Secondary) have been indicated. Certain portions of this history will be supplemented by complete daily charts in connection with ourdetailed discussion which follows.25
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Technical Analysis of Stock Trends
220DOW-JONES INDUSTRIALS
200
180
160
140
70
INDUSTRIALS
120
60
100
50RAILS40
80
30RAILS20
’41
’42
’43
’44
’45
’46
FIGURE 2. “Swing” (EN: OR Wave) chart showing all the Intermediate and someof the more extensive Minor Trends of the Dow–Jones Industrial and Rail Averages,January 1941 to December 1946. Industrial price scale left, Rails right.
The year 1941 opened with the stock market in a Minor Rally. A PrimaryBear Market had been signaled when prices collapsed in the spring of 1940,and that Bear Market was still in effect. After the May Panic had ended, aSecondary Recovery swing, which lasted for more than 5 months, hadregained more than half of the ground previously lost by the Averages,carrying the Industrials from their closing price of 111.84 on June 10 to 138.12on November 9 and the Rails from 22.14 on May 21 to 30.29 on November 14.(During this long Bear Market Secondary, incidentally, volume tended toincrease on rallies, which encouraged many who did not hold strictly to firstprinciples to believe that this rise was the beginning of a new Bull Trend,illustrating the point we cited under “Volume” in Chapter 3.) From theNovember highs, however, the trend turned down again. Then a Minor Rallydeveloped, as we have said, at the end of the year, reaching its peak onJanuary 10 at 133.59 in the Industrials and 29.73 in the Rails. From there,prices fell again to 117.66 and 26.54, respectively, on February 14.
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27
130128126
INDUSTRIALS
1241221941
120118
31
116
30
RAILS
29
Total Vol.
Sales inMillions
282726
2.01.51.0.5FEBRUARY8 15 22 1
JULYMARCHAPRILJUNEMAY8 15 22 29 5 12 19 26 3 10 17 24 31 7 14 21 28 5 12 19 26 2
AUGUST9 16 23 30
FIGURE 3. Closing price levels of the Dow–Jones Industrial and Rail Averages,February 1 to August 31, 1941, and total daily market volume. Vertical lines shownet daily change from one closing level to next.
The First Severe TestThe next few months will be particularly interesting for us to trace becausethey put the Dow Theory to a real test. Figure 3 shows the daily ranges andclosing prices of the two Averages and total daily market volume for the7 months from February 1 to August 31, 1941. Before we examine it in detail,however, let us first review the situation on February 14. The Bear Marketlows to date had been registered in May–June, 1940. Thereafter, an extendedIntermediate Recovery had advanced the Industrial Average 26.28 pointsand the Rail Average 8.15 points. This had been followed by a 3-monthdecline of 20.46 and 3.75 points, respectively, and this decline, incidentally,had consisted of three well-defined Minor Waves. In duration, and in extentof price change with respect to the previous swing — 46% in the Rails andnearly 78% in the Industrials — this downswing qualified as an IntermediateTrend, and now prices were turning up again. Dow theorists were on thealert. If both Averages could continue their rise to levels above their highcloses of the previous November (138.12 and 30.29), that action would constitute a signal of a new Primary Bull Market, and reinvestment of fundswithdrawn from stocks in May 1940 would be at once in order. Also, it wouldthen be necessary to go back and label the May–June lows of 1940 as theend of a Bear Market, the advance to November as the first Primary Swingin the new Bull Market, and the decline to February as its first Secondary
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Reaction. But note that Rule 12 of our preceding chapter applied here; thepresumption was that it was still a Bear Market until a definite signal to thecontrary appeared.Let us now turn again to Figure 3 and see what actually did happen.The Industrials rallied for 6 weeks, reaching 124.65 on April 3. The Rails gotup to 29.75 on the same date, registering double the percentage gain of theIndustrials, but both Averages were still below their November highs. Thenthe Industrials slipped off within 2 weeks, and had broken down below theirFebruary low and drifted down to close at 115.30 on May 1. This Averagewas, therefore, still in an Intermediate Downtrend. But the Rails, meanwhile,were staging a different sort of performance. They dropped back from theirApril 3 high for 2 weeks, but held at 27.72, rallied smartly and then sold offagain to 27.43 on May 31. The picture became at once even more interesting.Here was a Divergence between the two Averages, a failure to confirm; theRails, after two opportunities, were refusing to confirm the Industrials in thelatter’s downtrend.
Failure to ConfirmWhen prices began to work upward in June, many commentators seizedupon this “failure to confirm” as a Bullish omen and the wishful thinkersagain talked Bull Market. There is an unfortunate tendency in “the Street”to overstress any such divergence, particularly when it can be twisted intoa favorable sign. The fact is that, in Dow Theory, the refusal of one Averageto confirm the other can never produce a positive signal of any sort. It hasonly negative connotations. Divergences sometimes occur at Reversals in theMajor Trend — there have been several instances in market history, in which,perhaps, the most remarkable occurred way back in 1901 and 1902, and weshall soon inspect another — but they also occur with equal frequency attimes when no Major Reversal is developing, and the instance we are discussing here was one of the latter.So the situation at the end of May in 1941 was precisely the same to theDow theorist, insofar as the Major Trend was concerned, as it had been onFebruary 14. The June–July rally topped out in the Rails at 30.88 on August1, and in the Industrials at 130.06 on July 28 (compare these figures withtheir 1940 November highs) and prices then declined at an accelerating pacewhich culminated, temporarily, in the “Pearl Harbor” Panic. This took theIndustrial Average below its previous Bear Market low (111.84 on June 10,1940), although the Rails, again, did not follow. They had, however, by thistime, broken below their previous (February 14) Intermediate Bottom by aliberal margin.The next period of importance began in April 1942. We can skip anydetailed chart of the months between December and April because theyposed no Dow Theory problems. After a Minor Rally in the Rails in January,prices simply drifted lower and lower, but it was increasingly evident thattrading volume did not expand on the dips (Minor Declines). Liquidation
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INDUSTRIALS19423029282726252423
RAILS
Total Vol.
Sales inMillions
11611411211010810610410210098969492
The Dow Theory in Practice
2.01.51.0.5MARCH
APRIL
MAY
JUNE
JULY
AUGUST
SEPTEMBER
OCTOBER
7 14 2128 4 11 18 25 2 9 16 23 30 6 13 20 27 4 11 18 25 1 8 15 22 29 5 12 19 26 3 10 17 24 31
FIGURE 4. Daily closing price levels of the Dow–Jones Industrial and Rail Averagesfrom March 2 to October 31, 1942, and total daily market volume. This period sawthe beginning of a 4-year Major Bull Market.
was drying up; the boardrooms were void of customers; the atmosphere wastypical of the last stages of a Bear Market.Figure 4 shows the daily action of the Averages from March 2 toOctober 31, 1942. New lows (since 1940) were registered in both in late April,at 23.72 on April 24 in the Rails and at 92.92 on April 28 in the Industrials.Shortly thereafter, a notable Divergence developed, when, after rallying foronly 7 days, the Railroad Index began to slip off while the other Averagekept right on going up. Trading activity remained at a low ebb (there wasno sustained volume increase, in fact, until late September). On June 1, theRails dropped to another new low and on the 2nd closed at 23.31. On June22, it looked as though the Industrials were going to be pulled down again,but only a few days later, the best rally in months got started, taking theIndustrials to new highs and more than recovering all of the April–May lossin the Rails. Activity also speeded up briefly, with one day registering agreater turnover than the market had enjoyed in any session since earlyJanuary. EN9: Note this warning sign. The ringing of an alarm clock.
Signs of Major TurnAgain the Dow theorists were very much on the alert. An advance of Intermediate proportions was obviously under way. Until proved otherwise, it hadto be labeled a Secondary within the Bear Market which was still presumably
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in effect, but that Major Downtrend had by now run for nearly 3 years —nearly as long as any on record — and its last decline had shown no sellingpressure whatever, simply a dull drift. This presumed Secondary might turnout to be, instead, a new Primary; hopes for such a denouement had beenblighted 12 months earlier under somewhat similar circumstances, but thistime prices were lower and there was a different “feel” to the market. Thegeneral news offered little encouragement, but the Dow Theory does notconcern itself with any news other than that made by the market itself (whichdiscounts all other kinds of news). In any event, there was nothing to do butwait and see — let the market, in its own time and way, state its own case.In early July, the Industrials started to “mark time”; for 11 weeks, theyfluctuated within a 5-point range, building a typical Dow Line from whichthey emerged on the upside in late September. The Rails pushed up to a newhigh for the move at the same time, and by November 2, both Averages hadsurpassed their Rally Tops of the preceding January. At this stage, some Dowtheorists were willing to announce that a Bull Market had been signaled.Their arguments, aside from points of a nontechnical nature or having nothing to do with Dow Theory, were:1. The conspicuously low level of volume at the April–June Bottom,typical of the end of a Bear Swing. (True and cogent.)2. The Rail Average had refused to follow the Industrials into new Majorlow ground at that time. It had held above its closing level of May1940. (Also true, but of questionable significance. More about thislater.)3. The Industrials had constructed a Line and gone up out of it. (Againtrue, but the Line was somewhat short to have, beyond a doubt,major import.)4. The Rail Average had for 4 months produced successively higherMinor Tops and Bottoms. (And this also was true but did not permitof positive differentiation from a Bear Market Secondary.)The more conservative Dow theorists were not yet convinced. Theymaintained that this uptrend had yet to undergo the test, bound to occursooner or later, of an Intermediate Reaction. They admitted that the picturewas most encouraging, but called attention to the fact that, except for Point1, it was no better than that of November 1940. Let’s follow along throughthe next 5 months. Figure 5 shows the daily market action from November1, 1942, to June 30, 1943.
The Bull SignalAfter reaching 29.28 at their close on November 2, the Rails declined inalmost a straight line for 6 weeks to 26.03 on December 14. This moveindubitably rated as an Intermediate in duration, and it had “given up” morethan half of that Average’s entire advance from the June 2 low point. The
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Sales inMillions
142140138136134132130128126124122120118116114
The Dow Theory in Practice
31
INDUSTRIALS
RAILS
1942–1943
38373635343332313029282726
2.01.51.0.5NOVEMBER DECEMBERJANUARY FEBRUARYMARCHAPRILMAYJUNE7 14 21 28 5 12 19 26 2 9 16 23 30 6 13 20 27 6 13 20 27 3 10 17 24 1 8 15 22 29 5 12 19 26 3
FIGURE 5. Daily closing price levels of the Dow–Jones Industrial and Rail Averagesfrom November 2, 1942, to June 30, 1943, and total daily market volume. This chartfollows and should be compared with Figure 4. The decline in the Rail Averageduring November and early December produced the first test of the Major Trendsince the preceding June. When this Index recovered and, on February 1, 1943, closedabove its November 2 high, a Primary Bull Market was thereby signaled accordingto Dow Theory.
Industrial Index, however, held stoutly in another narrow Line throughoutNovember, December, and January. From December 14, the Rails turned up,and finally, on February 1, 1943, closed at 29.55, out above their previousIntermediate Top of 29.28 recorded the previous November. By then, theIndustrials had also moved up into new high ground. This development atlast satisfied every strictest requirement of Dow Theory; a new Primary BullMarket was in force. Trading volume had also been expanding on each MinorAdvance during the fall and winter months, but its evidence was not needed;the price action alone was conclusive. The Rails had produced the necessarysequence of higher Intermediate Tops and Bottoms. In the Industrials, Lineshad served the purposes of the theory as substitutes for Intermediate Reactions.It was necessary now to relabel the up-move from April–June to November of 1942 as the first Primary Swing in a Bull Market. The decline of theRails from November 2 to December 14 was now recognized as the firstSecondary within that Major Trend.
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We may turn back for a moment at this point to comment on the performance of the Rail Index in June 1942. Because it held then above its lowof May 1940, some commentators have maintained that the Bull Marketshould really have been dated from that former year as representing the last“confirmed” lows. This strikes us as rather impractical hair-splitting. Regardless of the