April 6, 1956, as against the $11,236.65 derived fromthe straight Dow Theory program.EN: This record of the Dow Theory is updated to the year 2006 in Chapter 5.1.
The Dow Theory Is Not InfallibleOf course, it isn’t. It depends on interpretation and is subject to all thehazards of human interpretive ability. But, again, the record speaks for itself.
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Table 1. The Dow Theory’s 60-Year RecordOriginal fund$100.00
Date
InvestedStocks soldProceeds reinvestedStocks soldProceeds reinvestedStocks soldProceeds reinvestedStocks soldProceeds reinvestedStocks soldProceeds reinvestedStocks soldProceeds reinvestedStocks soldProceeds reinvestedStocks soldProceeds reinvestedStocks soldProceeds reinvestedStocks soldProceeds reinvestedStocks soldProceeds reinvestedStocks soldProceeds reinvestedStocks soldProceeds reinvestedStocks soldProceeds reinvestedStocks sold
July 12, 1897December 16, 1899October 20, 1900June 1, 1903July 12, 1904April 26, 1906April 24, 1908May 3, 1910October 10, 1910January 14, 1913April 9, 1915August 28, 1917May 13, 1918February 3, 1920February 6, 1922June 20, 1923December 7, 1923October 23, 1929May 24, 1933September 7, 1937June 23, 1938March 31, 1939July 17, 1939May 13, 1940February 1, 1943August 27, 1946October 2, 1950April 2, 1953January 19, 1954October 1956
Industrialaverage price44.6163.8459.4459.5951.3792.4470.0184.7281.9184.9665.0286.1282.1699.9683.7090.8193.80305.8584.29164.39127.41136.42142.58137.50125.88191.04228.94280.03288.27468.70
Percentgain
Proceeds
43.1
$143.10
0.3
143.53
80.0
258.35
21.0
312.60
3.7
324.17
32.5
429.53
21.7
522.74
8.5
567.17
226.1
1849.54
95.0
3606.61
7.2
3866.29
(Loss 3.6)
3727.10
51.9
5653.71
22.3
6911.01
62.6
11,236.65
The Dow Theory Frequently Leaves the Investor in DoubtThis is true in one sense and not in another. There is never a time when theDow Theory does not afford a presumptive answer to the question of thedirection of the Primary Trend. That answer will be wrong for a relativelyshort time at the beginning of each new Major Swing. There will also betimes when a good Dow analyst should say, “The Primary Trend is stillpresumably up, but it has reached a dangerous stage, and I cannot conscientiously advise you to buy now. It may be too late.”Frequently, however, the above objection simply reflects the inability ofthe critic mentally to accept the fundamental concept that the Averagesdiscount all the news and statistics. He doubts the Dow Theory because he
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cannot reconcile its message with his own ideas, derived from other sources,of what stocks should do. The theory, needless to say, is usually more nearlyright.This criticism in other cases reflects nothing but impatience. There maybe weeks or months (as, for example, during the formation of a Line) whenthe Dow Theory cannot “talk.” The active trader quite naturally rebels. Butpatience is a virtue in the stock market as elsewhere — in fact, essential ifserious mistakes are to be avoided.
The Dow Theory Does Not Help the IntermediateTrend InvestorThis is perfectly true. The theory gives little or no warning of changes inIntermediate Trend. Yet, if a fair share of these can be captured, the profitamounts to more than can be derived from the Primary Trend alone. Sometraders have worked out supplementary rules based on Dow principleswhich they apply to Intermediate Movements, but these have not proved tobe satisfactory. The remainder of our book is devoted to a better approachto this problem.The Dow Theory is a mechanical device, designed to tell the directionof the Primary Market Trend, which is important because, as we said at thebeginning of this study, most stocks tend to go with the trend. The DowTheory does not and cannot tell you which individual stocks to buy, asidefrom those stocks which make up the averages themselves. That, again, is aproblem for the remainder of this book.EN: An Old Criticism, obsolete in Modern Markets. The Dow Theory does nottell you which stocks to buy. True at the time Edwards wrote this. But in modernmarkets the investor can buy substitute instruments which almost perfectly mimicits behavior (DIA). As it is possible to trade in surrogates for the Dow Averages inpresent markets, see Chapter 15.1.
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chapter 5.1
The Dow Theory in the 20thand 21st CenturiesAs may be seen in the following table, replacing the table from Chapter 5,the Dow Theory continued to provide its user an advantage over theunaware Buy-and-Hold Investor. From its original investment of $100 in1897 the Theory investment would have grown to $345,781.94 by December31, 2005, with the long trade still open. The table below shows the details,including the post-2000 bust drawdown. To my mind this table is a powerfuldemonstration of the power of methodical technical investing.By contrast, the investment of $100, if bought at the low, 29.64, and sold atthe historic high, 11762.71, in January 2000 would have grown to $39,685.03.
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I am indebted to Jack Schannep of The Dow Theory.Com (www.thedowtheory.com) for the data recapitulated here. At that URL an enlightening expositionof the Theory and its record may be found — much more complete than thatwhich is found here outside of Edwards’ magisterial presentation.Minor discrepancies are acknowledged within these and others’ data, apoint which will be raised by purists. This is occasioned by disagreementswithin the priestly circles of those who keep the sacred records. That is, notall theorists are in 100% agreement as to the exact date or nature of thesignals. (Some will say the reentry date of October 1, 1956, should have beenOctober 7, 1957, for example.) Meaning, of course, that some judgment isinvolved in interpretation of the entrails. The Dow Theory is not a 100%objective algorithm, just as chart analysis is not reducible to an objectivealgorithm. (I am allowed to jest at the priesthood as I am a junior acolyte inthese matters. It would not be seemly for the uninitiated to burlesque.)In brief, an investment of $100 in 1897 would have become $345,781.94simply by buying the Industrial Average stocks each time the Dow Theoryannounced a Bull Market and holding them until the Dow Theoryannounced a Bear Market, then selling.The Technical Investor would have had this amount in pocket markedto market at the end of 2005 as opposed to the $39,685.03 of his dozingcounterpart, or the Trust Department of the Rip Van Winkle Bank of SleepyHollow. And, in addition, he would not have been deliquidified during BearMarkets.Whether or not the Dow Theory retains its validity over the market asa whole, there can be no question that it still calls the turn for its sector ofthe market, which as Jack Schannep correctly notes, has five times the capitalization of the NASDAQ.As Mark Twain observed, everybody talks about the Dow Theory, butnobody does anything about it. Perhaps that is not precisely what Twainsaid, but close enough for government work. As further inquiry into theinner workings of the Theory I have initiated a series of studies of the recordwith Brian Brooker, MS Finance, Golden Gate University. Following are someof the results of our study, from the monograph, Dissecting Dow Theory.
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It seems obvious that the risk characteristics of Dow Theory investingare unique, and I will belabor the obvious. The Buy-and-Hold Investormentioned above for comparison with the Dow Theory Investor not onlyrealized less profit over the period of his investment; he also experiencedgreatly expanded risk over the life of the investment. At first blush all theprofits garnered by the Reversing Investor in the table above represent riskactually experienced by the Buy-and-Hold Investor. But that is only firstblush. A little deeper thought reveals that the true extent of theBuy-and-Hold Investor’s risk is measured by maximum drawdowns overany given period of time. It is not necessary to theorize about this question.The measurement is empirical.When viewed in perspective these risks are startling. From the top in 2000to the low in 2002 a 39% drawdown occurred. Is this disquieting? A 41%drawdown occurred during the Reagan crash of 1987. A mere bagatelle. Thedrawdown from 1929 to 1932 was 89%. Of course such things are unlikely tohappen again. The big guys would step in and support the market.Clearly the way to reduce market risk to zero is to be out of the market.Less obviously, or perhaps blatantly, the second most important way toreduce risk is to be right the trend — or not to be wrong. And in fact becauseof the nature of the Theory much time is spent on the sidelines by the DowInvestor. A natural reduction of risk. In fact of the total days from 1897 to2006, 39,493, the Dow Investor spent 14,378 (or about 37% of the time) daysat the beach or at the S&L. But his accumlated profits have not been creditedwith interest as this is a “pure” study.As will be readily apparent Table 1.2 is much richer in data than just theduration of investments in the long side of the market. Acting on the maxim(my own) that it is unwise to invest on only one side of the market I havecomputed the accumulated profits gained by trading the Dow long andshort. After all the market goes down as well up, and for a reversing systema liquidation of longs is a signal to go short. If the record on the long sideis impressive, showing accumulated profits to 2006 of $345,781.94, how muchmore impressive is the accumulated profit of $1,902,859 garnered from trading both sides of the Dow, long and short.The reader who listens carefully will hear the meta message here. Forthe great majority of investors it is the long run which is important. In the“right now” culture of the Internet and the computer and get rich quick onewonders if there are still such investors, outside of the very rich and veryintelligent. Perhaps there are still a few aged readers of early editions of thisbook. And, not to despair, perhaps some new converts.In Figures 9.1 and 9.2 I practice what I preach. I post historical DowTheory buy and sell signals on the Dow chart. I am constantly urging students and clients to take the chart of an issue they have done poorly (orwell) in and post their trades on it. The mere examination of this kind ofchart should be an enlightening experience. When this exercise is accomplished the investor may see whether in fact he is operating according to
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05
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18171620
27
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3029
3132
343533 36
70
48
75
4037 41 464739 42 4538 4344
55156020652530354045501998—2004 Prophet Financial Systems, Inc. Terms of use apply.
12
1314
2423252622
21
– 0.42%
40
70
140
210
280
350
1050910840770700630560490420
FIGURE 9.1. To my knowledge the only charts existing of the performance of the Dow Theory from beginning to2006. The numbers on the charts of the Dow in figures 9.1 and 9.2 are keyed to the row numbers of Tables 1.1 and 1.2.In the tables the reader may see the exact date and price of the Dow Theory transaction by finding the matchingnumber. Thus, Number 19 represents the sale of the portfolio on November 23, 1929 at 305.85 during the Great Crash.
4
8
9 1110
19
– 47.14
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7
DOW JONES 30 11270.29
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85
90
95
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© 1998-2004 Prophet Financial Systems, Inc. All rights reserved.
80
05
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570
The Dow Theory in the 20th and 21st Centuries
FIGURE 9.2. The second half of graphic representation of the timing of DowTheory signals from beginning to 2006. Note Number 82.
70
800
1600
2400
3200
4000
4800
5600
6400
11270.29104009600880080007200
Chapter 5.1:
65
DOW JONES 30 11270.29 −47.14 −0.42%
$INDU (Dow Jones Industrial Average Index)03/23/2006 11:54 PM EST (all, monthly)
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sound methods. Sound Methods being, in the opinion of this book and thisEditor, mid- to long-term trend following methods.Further, these charts of the Dow Theory method may be compared withFigures 210 and 210.1 showing the use of Basing Points and the reader willhave extensive cases of two methods for following the market in additionto the chart analysis methods prevalent thoughout the book.Robert W. Colby (robertwcolby.com), a member of the Market Technicians Association (mta.org), in a paper published by that organization (andavailable at his website), explored many objective algorithms for duplicatingthe performance of Dow Theory. Among these is a naturalistic channelbreakout algorithm which I find worth further investigation. I will quote therules here without further comment, reminding the reader that no (repeatNO) system should EVER be backed with money until the trader has exhaustively vetted it. Colby’s algorithm:1. Enter Long (Buy) when INDU rises to a new 9-trading day high andTRAN rises to a new 39-trading day high.2. Close Long (Sell) when INDU falls to a new 22-trading day low andTRAN falls to a new 166-trading day low.3. Enter Short (Sell Short) when INDU falls to a new 22-trading daylow and TRAN falls to a new 166-trading day low.4. Close Short (Cover) when INDU rises to a new 36-trading day highand TRAN rises to a new 32-trading day high.
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chapter six
Important Reversal PatternsIn our discussion of certain deficiencies in the Dow Theory from the pointof view of the practical trader, we mentioned the fact that it did not tell uswhat specific stocks to trade in. (EN9: Obviously no longer a problem as theinvestor may buy the DIA and trade the Average like a stock.) A conservative andwealthy investor, more interested in safety than maximum profit, can solvethis problem by making up a comprehensive and thoroughly diversified listof sound, well-seasoned “blue chip” issues and handing his broker an orderto buy the lot when the Dow Theory signals a Bull Trend. Some of hisselections will do better than others; some may “go sour,” but wide diversification will ensure his getting a fair Average result. Better results shouldbe obtained if we can find a way to select for purchase the most favorablysituated issues at any given time, and can manage to sell them promptlyand switch to others whenever the prospects for the first have been fullydiscounted.There is the possibility, too, of increasing our gains if we can, at times,buy with safety earlier in an uptrend than the Dow theorist does, and sellbefore the market has reacted far enough to give a Dow Bear Signal.We mentioned also the fact that the Dow Theory is of little or no assistance in trading on the Intermediate Trends. There is obviously more moneyto be made if we can get the benefit of all of each up move without havingto write off some of our profits in each reaction. Or if we can profit bothways by trading on both the “long side” and “short side” of the market.Finally, although all stocks tend to move with “the market” as typifiedin the Averages, there are in fact wide variations in the price paths of individual issues. An average, after all, is just that, a device for expressing inone figure a diversity of other figures. A Primary Bull Market ended in theDow–Jones Industrial Average on May 29, 1946; but United Air Lines registered its highest price in December 1945; General Motors saw its peak inJanuary 1946; Goodyear in April, DuPont in June, and Schenley in August.Is there a way of capitalizing on these Divergences?Technical analysis of the charts of individual stocks definitely answersthe first and most important of these four problems, the matter of selection.It frequently, but not always, gives us a running start on the Dow Theory;it also, in large part, takes care of the question of the Intermediate Trend,although there are certain reservations as to policy and risk in connectionwith both these points which will be taken up in due course. Finally, careful55
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technical analysis should, in nearly every case, get us out of a stock that“tops out” ahead of the Averages long before it has suffered any considerabledecline, often in time to transfer funds to other issues which have yet tocomplete their advances.Just as the Averages constantly discount all known and foreseeable factors affecting the future of security prices in general, in the same way doesthe market action of an individual issue reflect all the factors affecting itsindividual future. Among these factors, and, expressed in its chart, are thegeneral market conditions which influence all stocks to a greater or lesserdegree, as well as the particular conditions applying to the particular stock,including the operations of “insiders.”Let us assume right from the start that you, the reader, are not a memberof that mysterious inner circle known to the boardrooms as “the insiders.”Such a group — genuinely entitled to be called insiders, thoroughly informedon every fact, figure, and development that might determine the fortunes ofa certain corporation — may exist from time to time, may influence themarket price of its stock (EN9: and wind up in prison). But it is fairly certainthat there are not nearly so many “insiders” as the amateur trader supposes,and that they do not cause one tenth of the market movements for whichthe public blames them. It is even more certain that insiders can be wrong;they would, in fact, be the first to admit it. Frequently, their plans are upsetby some development which they could not foresee, or by some blind forcewhich puts to scorn all expert estimates of value. Any success they have,however, can be accomplished only by buying and selling on the floor ofthe Exchange. (EN9: No longer strictly true. Insiders sold stock to their companiesin the tulip bubble which went unreported publicly for up to a year. Still, only anisolated problem.) They can do neither without altering the delicate poise ofsupply and demand which governs prices. Whatever they do is sooner orlater reflected on the charts where you, the “outsider,” can detect it. Or detect,at least, the way in which the supply–demand equation is being affected byinsiders’ operations plus all other prevailing market factors. So, you don’tneed to be an insider in order frequently to ride with them.
Important Reversal PatternsStock prices move in trends. Some of those trends are straight, some arecurved; some are brief and some are long-continued; some are irregular orpoorly defined and others are amazingly regular or “normal,” produced ina series of action and reaction waves of great uniformity. Sooner or later,these trends change direction; they may reverse (as from up to down) orthey may be interrupted by some sort of sideways movement and then, aftera time, proceed again in their former direction.In most cases, when a price trend is in the process of Reversal, eitherfrom up to down or from down to up, a characteristic area or “pattern” takesshape on the chart, becomes recognizable as a Reversal Formation. Some ofthese chart pictures are built and completed very quickly, while others may
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require several weeks to reach a stage where one can surely say that a reversalof trend is definitely indicated. Speaking in broad generalities, the greaterthe Reversal Area — the wider the price fluctuations within it, the longer ittakes to build, the more shares transferred during its construction — themore important its implications. Thus, roughly speaking, a big ReversalFormation suggests a big move to follow and a small pattern, a small move.Needless to say, the first and most important task of the technical chartanalyst is to learn to know the important Reversal Formations and to judgewhat they may signify in terms of trading opportunities.There is one recognized Reversal Pattern which appears and is completed within a single day’s trading, and is, in consequence, named the“One-Day Reversal.” There are times when it has great significance as callinga halt, at least temporarily, to any up or down move, but in its ordinarymanifestations it does not imply much of an immediate move in the oppositedirection. It is a useful pattern and we shall have more to say about it later.But the price formations from which extensive new trends proceed take timeto build. One does not bring instantly to a stop a heavy car moving at 70 milesan hour and, all within the same split second, turn it around and get itmoving back down the road in the opposite direction at 70 miles an hour.
Time Required to Reverse TrendBut we do not need to lean on a racing automobile analogy to explain whyit takes time (and volume and price action) to produce an important TrendReversal. The logic of it is plain enough, if we take but a moment to examineit. We can do so most easily by describing what might have (and, doubtless,many times has) happened in specific terms. Suppose a certainwell-informed and well-financed coterie (EN9: A congerie of mutual funds, forexample.) decides that the shares of a certain company, now selling around40, are cheap, that this company’s affairs are progressing so satisfactorilythat, before long, it will attract the attention of many investors and its stockwill be in demand at much higher levels, perhaps at 60 or 65. Our grouprealizes that if they manage their market operations skillfully, if nothingunforeseen intervenes to upset their calculations, they can “take” 20 pointsout of the situation. So they proceed to buy in all offerings, going about thisbusiness as quietly as possible, until they have accumulated their “line,”which may run to several thousand shares and represent practically all ofthe current floating supply of the issue. Then they wait. Presently, professionals become suspicious and the rumor circulates that there is “somethingdoing in PDQ,” or other canny bargain hunters discover the company’sbright prospects, or chart analysts detect the signs of accumulation in thestock’s action. Buyers now find that the stock is scarce; there are few offeringson the books and they have to raise their bids to get it. An advance starts.The up-move gathers momentum as more and more traders areattracted by rising prices. It is helped along by the good reports (higherearnings, increased dividend, etc.) which our group knew were to be
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expected. Eventually, prices approach the level at which they had plannedto take profits. But this operation, the “distribution” of their holdings, mayrequire even more patient and skillful handling than did the accumulation.Suppose they have 20,000 shares to unload. They cannot throw all on themarket at once; to do so would defeat their own ends immediately and,perhaps, permanently. They must feed their line out little by little, trying toavoid attention, feeling their way along and never permitting a surplus ofofferings to kill the demand. If activity in their stock has reached a level of,say, 2000 shares transferred daily, they may be able to dispose of 500 sharesa day from their holdings without bringing the price down. (They will becompeting, sooner or later, with others who have followed their play, whobought lower down and will be ready to take profits as soon as the advanceshows signs of weakening.) So they start to sell when the rising Trendappears to have attained maximum momentum, or as it nears their priceobjective, but well before it has reached its probable limit, and they pushout their shares as rapidly as buyers will take them.Before long, as a rule — before they have distributed their entire line —a lull in demand will occur. Perhaps prospective buyers sense the increasein supply. A reaction develops. Our group quickly ceases selling, withdrawsits offers, perhaps even buys back a few shares to support prices if theythreaten to drop too far. With supply temporarily held off the market, thedecline halts and the advance resumes. Our group lets it proceed this timeuntil it carries prices into new high ground; this reassures other holders andbrings in more buyers. As soon as the pot is once again merrily boiling,distribution is started anew and, if the maneuver has been well directed,completed in perhaps 2 or 3 weeks, before the second wave of demand hasbeen exhausted.Our group is now out of its stock with a nice profit; its 20,000 shareshave passed into other hands. If they gauged the market correctly anddistributed their line at a price about as high as the situation would bear,demand will have been satiated for a long time to come. Prices will probablyfirst drift back to somewhere near the level where they were supported onthe previous dip, then rally feebly on the strength of a little new buying fromtraders who were waiting for just such a Minor Reaction, meet sales fromother traders who failed to seize the opportunity to take their profits on thepreceding volume Top and are now anxious to get out, and then break downinto a decline of Intermediate or Major proportions.You can see now why, under one specific set of circumstances, a Toparea, a chart pattern of distribution, takes time and volume to complete. But,it doesn’t matter whether we have to deal with the highly organized operations of a single group of insiders or of an investment syndicate or, as ismore often the case, with the quite unorganized activities of all the investorsvariously interested in an issue. The result is pretty much the same. Distribution, which is simply the Street’s way of expressing the process of supplyovercoming demand, takes time and a change in ownership (turnover) of a
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large number of shares. And it is amazing to see how these patterns ofdistribution, which hereafter we shall find it simpler to refer to as “Tops,”tend to assume certain well-defined forms. Most of the same pattern formsappear also as “Bottoms,” in which manifestation they signify accumulation,of course, instead of distribution.
The Head-and-ShouldersIf you followed closely and were able successfully to visualize how the foregoing example of