1.17 higher level in the Rail Average in June 1942, a genuine BullMove did not start until that time. We suspect that before many years havepassed, Dow theorists will have occasion greatly to regret the importancewhich has since been assigned to the Rails’ “failure to confirm” in the springof 1942. Remember, such a Divergence does not and cannot produce a positive signal; at the time of its occurrence, it can serve merely to negate orcast in doubt the implications of the other Average; only subsequent actionin the opposite direction can establish the existence of a change in trend. Ifthe Rails’ decline in May 1942 had carried them below 22.14, but theirsubsequent action had followed the course which it actually did, point forpoint but at a lower level, a Bull Market Signal would nevertheless havebeen given at the very same time, not one day later and not one day sooner.Moreover, a Divergence does not necessarily imply that a move of consequence in the opposite direction will ensue. We have already examinedone comparable instance (in the spring of 1941) which resulted otherwise.Logically, also, if a failure to confirm such as occurred in 1942 is to be takenas an indication of a turn in trend, then its opposite, i.e., confirmation orreaffirmation by both Averages, should argue with equal force against a turnin trend. Yet the simple truth is that many more Major Reversals have comewhen the Averages were in agreement than when they were divergent. Wehave no wish to belabor the point or waste the reader’s time, but we do feelthat he should be warned against the wishful thinking that every “failure toconfirm” seems to inspire when the market is in a Bear Trend.To return to our history, the Averages closed at 125.88 and 29.51, respectively, on the day following our conclusive Bull Market Signal in February1943. Theoretically, there is where an investor who followed the Dow Theorystrictly would have bought his stocks. (Those who were satisfied that thePrimary Trend was up in November 1942 bought with Averages around114.60 and 29.20.) It was reasonable to assume that this Bull Market, whichas yet showed few of the usual characteristics of the second phase and nonewhatever of the third phase, would continue for some time to come. Thenext 4 months produced no market developments that required interpretative attention, and we can move on to the events of July. Figure 6 charts theaction from July 1, 1943, to January 31, 1944.
The First CorrectionAfter closing at 145.82 on July 14, 1943, the Industrial Average drifted off.The Rails pushed up to a new high (38.30) 10 days later, but the Industrialsrefused to join in the rally and then both indexes cracked down sharply for7 sessions. Turnover increased and the decline was the greatest that had
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146144
INDUSTRIALS
1943–1944
142140138136134132
37RAILS
36
130
3534
Total Vol.
Sales inMillions
333230
2.01.51.0.5OCTOBER NOVEMBER DECEMBERJULYAUGUST SEPTEMBER3 10 17 24 31 7 14 21 28 4 11 18 25 2 9 16 23 30 6 13 20 27 4 11 18 25 1
JANUARY8 15 22 29 5
FIGURE 6. Daily closing prices of Dow–Jones Industrial and Rail Averages, andtotal market volume, July 1, 1943, to January 31, 1944.
occurred in the Bull Market up to that date. But, everyone realized that themarket, after several months of quite persistent advance, was “entitled to acorrection.” In neither duration nor extent could this down move be qualifiedas more than a Minor Trend. Next ensued 3 months of desultory fluctuationwith little net progress in either Average. The Industrials pulled up to 141.75on September 20 and then drifted off again, while the Rails struggled backto 35.53 on October 27. Another quick break developed in early November,culminating in a high-volume shakeout which cut the value of the Industrialsby 3.56 points and the Rails by 1.75 on November 8. Prices rallied a little andsold off again, reaching new lows (since early spring) on November 30 —Industrials 129.57 and Rails 31.50.There was no question now but that a full-fledged Secondary Reactionhad developed. The problem for Dow interpreters was whether more thanthat was involved. If the first drop in July could be construed as an Intermediate Trend in itself, and the August–October action as another Intermediate Swing, then the November break would signal a Bear Market. As amatter of fact, no Dow theorist, so far as we know, gave very serious consideration to any such interpretation. The July break, as aforesaid, did notrate as an Intermediate in either duration or points retraced; the whole movefrom July to November 1943 had to be regarded as all-of-a-piece, all oneSecondary Reaction. The real Major Trend test would come on the nextadvance, whenever that should develop; if that failed to top the July peaks,and prices thereafter declined to new lows, a Bear Market would indeed bein effect.
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The decision was long deferred. Prices began again to move up, but theadvance in the Industrials was slow and grudging. The Rails forged aheadmore rapidly and pushed through their July Top on February 17, 1944, goingon to a Minor Peak at 40.48 on March 21. The Industrial Average attained141 on March 13, but still nearly 5 points below its “signal” level, falteredand fell back. Here was another striking case of “failure to confirm.” Forthose who chose to assign grave significance to such developments, it couldhave only a very Bearish meaning. But all it did mean, in fact, was thatcontinuation of the Primary Bull Move had not as yet been confirmed. Onlyif both Averages now declined and closed below their respective November30 Bottoms would the new high registered by the Rails alone in Februaryhave to be disregarded and a Primary Bear Market announced. In brief, thesituation at the end of March was no different, so far as its Major Trendimplications were concerned, from what it had been in early January beforethe Rails pushed through.
Bull Trend ReaffirmedThe situation remained in doubt (but subject always to that basic presumption of the Dow Theory which we named as Number 12 in the precedingchapter) until June 15, 1944, when the Industrials finally came through toclose at 145.86. It had taken them 4 months to confirm the Rails, almost afull year to reaffirm the Primary Uptrend. The effect of this “signal” ontraders was electric; trading volume increased by 650,000 shares on thefollowing day as prices jumped another full point.The following 12 months need no detailed discussion as they producednothing in the way of market action to give a Dow theorist any concern.Prices drifted off irregularly for 9 weeks after mid-July but their net loss wasof minor proportions, and they then climbed with only brief interruptionsto 169.08 in the Industrial Index on May 29, 1945, and 63.06 in the Rail Indexon June 26, 1945. We should take a brief look at the period which followed,not because it illustrates anything new in our study, but because it takes inthe surrender of Japan and the end of fighting in World War II.Figure 7 covers the 7 months from May 1 to November 30, 1945. TheIndustrials held steady for 4 weeks while the Rails were making the spurtto their June 26 Top. On June 28, with nothing in the newspaper headlinesto account for such a radical trend change, prices broke sharply and turnoverclimbed to nearly three million shares, the highest day’s total for the BullMarket up to that time. But the Industrial Average gave ground reluctantlythereafter, and by June 26, at 160.91 had given up less than 5% of its topprice. The Rails shook down rapidly, however. The Hiroshima bomb wasdropped on August 5 and Japan surrendered on the 14th. The Industrialswere now rallying up from their July 26 low, but the Rails couldn’t hold andplunged again, hitting bottom finally (for this move) on August 20 at 51.48,for a loss of more than 18% of their June peak value.
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192188184180176172
INDUSTRIALS
66
168
64
164160
6260
RAILS
5856
Total Vol.
Sales inMillions
1945
545250
2.01.51.0.5MAY5 12 19 26 2
JUNEJULYNOVEMBERAUGUST SEPTEMBEROCTOBER9 16 23 30 7 14 21 28 4 11 18 25 1 8 15 22 29 6 13 20 27 3 10 17 24 31
FIGURE 7. Daily closing price levels of the Dow–Jones Industrial and Rail Averagesfrom May 1 to November 30, 1945, and total daily market volume. This period, whichsaw the end of World War II, produced only a moderate Secondary Correction in thePrimary Bull Market, which had already run for 3 years from its beginnings in April/June, 1942.
The Rails FalterBefore we go on with our examination of the market action here, it is interesting to note that, up to this point, the Rail Average had been the “hero”of our story. Starting with its refusal to go down to a new Bear Market lowin June of 1942, it was the spearhead of each important advance, had stagedthe most spectacular rallies, had gained 170% in value as compared with theIndustrials’ 82%. In retrospect, the explanation is obvious: the railroads werethe chief business beneficiaries of the war. They were rolling up profits,paying off indebtedness, and reducing their fixed charges at a rate unheardof in this generation (and probably never to be seen again). While the “public’s” eye was on the traditional and better publicized “war industries,” themarket began, as far back as Pearl Harbor, to shrewdly appraise and discountthis unprecedented harvest for the Rails. But from here on, the picturechanges and the Rails become the laggards. As we look back now, it is justas obvious that, with equal shrewdness, the market began in July of 1945 todiscount a change in their fortunes. An illuminating demonstration of thebasic assumption (Tenet Number 1) in Dow Theory!
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Turning back to our chart, prices began to push up again with renewedvigor after August 20. Both Averages had experienced a Secondary Reactionand now Dow theorists had to watch closely to see if the Primary Uptrendwould again be reaffirmed by their going to new highs. The Industrials“made the grade” when they closed at 169.89 on August 24, but the Railshad much more ground to recover and were running into offerings as theycame up in succession to each of the Minor Bottom levels of theirJune–August downtrend (a phenomenon to which we shall devote someattention later on in the chapter on Support and Resistance). Not until earlyNovember 1945 were they able to confirm the signal of the Industrials byclosing above 63.06. At this point, the Averages had, once again, announcedthat the Primary Bull Market was still in force. It had now lasted for threeand a half years — longer than most Bull Markets, and “third phase” signswere rapidly appearing. The public was buying, the boardrooms werecrowded, stock market news was making the front pages of even small citynewspapers, the “cats and dogs” were being whooped up, business wasbooming.With both Averages in new high ground and the Bull Market reaffirmed,all previous low points could now be disregarded. For example, the 160.91Bottom of July 26 in the Industrials and the 51.48 of August 20 in the Railshad no further significance in Dow Theory. This is a point we have notstressed heretofore, but it is important. It might, indeed, be added to our setof rules in the preceding chapter were it not implicit in the basic tenets. Oncea Primary Trend has been confirmed or reconfirmed, the past is forgottenand everything hinges on future action. At the end of 1945, with “thirdphase” symptoms rife, the action of the market had to be followed withredoubled vigilance. The third phase could last for 2 more years (as it didin 1927 to 1929) or be concluded at any moment. Our next chart (Figure 8)carries us through May 1946.
The Spring of 1946The market went through a Minor Setback in late December, a developmentwhich has come to be expected as the normal pattern for that month andwhich is usually attributed to “tax selling” — and stormed ahead again inJanuary 1946. Daily volume on January 18 exceeded 3 million shares for thefirst time in more than 5 years. During the first week of February, prices“churned” with little net change. Extreme high closes were registered duringthis period by the Rail Average at 68.23 on February 5, and by the IndustrialAverage at 206.97 on February 2. On February 9, both started to slide off,pulled back sharply from the 13th to the 16th, and then broke in a sellingwave that ran to a climax on February 26 with closings at 60.53 and 186.02,respectively. The loss in the Industrials was the greatest in points (20.95) theyhad suffered during the entire Bull Market; in the Rails, it was exceeded onlyby their July–August decline of the previous year. It amounted to a little
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216212208
INDUSTRIALS
2042001961921945–1946
188
7068
184RAILS
66
Total Vol.
Sales inMillions
646260
2.01.51.0.5DECEMBER8 15 22 29
5
JANUARY12 19 26
2
FEBRUARY9 16 23
2
MARCH9 16 23 30
6
APRIL13 20 27
4
MAY11 18 25
1
FIGURE 8. Daily closing price levels of the Dow–Jones Industrial and Rail Averagesfrom December 1, 1945, to May 31, 1946, and total daily market volume. Noteworthyfeatures of this period included the extremely high volume which prevailed duringJanuary and February as compared with lower turnover in April and May, and thelaggard performance of the Rails when the Industrial Average pushed up to a newhigh in April and again at the end of May. At the latter date, the February lows werestill the critical downside “signal” levels according to the Dow Theory.
more than 10% in the former and 11% in the latter, and gave up a little lessthan half of their advances from the 1945 summer lows. The decline was3 weeks old on February 26. It was an unqualified Intermediate — in DowTheory a Secondary Reaction presumptively within the still existing MajorUptrend.Labor troubles were dogging the steel and motor industries in 1946 fromearly January on, and a coal strike was looming. The February break wasattributed to those news developments, but the ruling cause was more likelythe discontinuance of margin trading. The Federal Reserve Board hadannounced in January that after February 1, stocks could be bought only forfull 100% cash. The late January up-fling was featured by the “little fellow”seizing his last chance to buy on margin. (Those who participated in thisscramble will doubtless regret it for a long time yet to come.) Professionalsseized the opportunity to unload their trading commitments, but the “littlefellow” was now temporarily out of funds; his brokerage account was
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quickly “frozen.” Under the circumstances, as we look back, it is amazingthat a more extensive Panic did not then eventuate.But the Dow theorist was not concerned with causes. The Bull Markethad been reaffirmed by both Averages in early February, canceling all previous “signal” levels. Bullish Forces were still evidently in effect because theFebruary 26 lows held and prices began to recover. The Industrials cameback quickly, and by April 9 had closed in new high ground at 208.03. TheRails dragged. When the market showed signs of weakening at the end ofApril, the Rail Average was still nearly 5 points below its early Februaryhigh. Was this another “failure to confirm” to worry about?
Final Up ThrustThe late February Bottoms were now the critical points on the downside; ifboth Averages should decline below the Intermediate Low closes thenrecorded, before the Rails could make a new high above 68.23 (in whichevent the Bullish Signal of the Industrials would be canceled), a Bear Marketwould thereby be signaled. But, despite a miner’s strike and an imminentrail workers’ strike, the market turned firm again in mid-May and put fortha surprising rally which swept the Industrial Index up to 212.50 on May 29,1946 — a new Bull high by nearly 6 points. The Rails failed in May by only0.17 to equal their February high close, slid back a trifle, and then pushedthrough at last on June 13 to close at 68.31, thereby confirming the Industrialsin their announcement that (as of that date) the Primary Trend was still up.The February lows (186.02 and 60.53) now ceased to signify in Dow Theory,but keep those figures in mind because they are involved in an argumentwhich raged among Dow students for months thereafter.Figure 9 overlaps the preceding picture, taking up the market’s actionon May 4 and carrying it forward to October 19, 1946. Trading volume, itmay be noted, in late May and early June did not come up to the levels ofeither the late January to early February Top or the late February Bottom;the market appeared to be losing vitality, an ominous, although by no means,decisive manifestation. Prices began to fall off rapidly immediately after theRail Confirmation on June 13. The Industrials rallied for 2 weeks in earlyJuly, but the Rails continued to decline; the Industrials broke again on July 15and the two Averages continued their slide until they stood at 195.22 and60.41 at the close on July 23.There, as it subsequently developed, was the end of that particularIntermediate Swing — one which in accord with our Rule 12 had to belabeled a Secondary Reaction in a Bull Market until proved otherwise. Themarket swung up again. It climbed slowly and steadily, but with turnoverrunning well under a million shares, until exactly 3 weeks later, the Industrials at 204.52 (August 13) had regained a little more than half of theirJune–July loss and the Rails at 63.12 (August 14) a little more than a thirdof theirs. This advance, therefore, had met the minimum requirements of anIntermediate Trend. If prices could continue to rise and eventually push
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216212208204200INDUSTRIALS19619270188
68
184
66
180
64
176
62
RAILS172
60
168
58
164
56
160
5452501946
46
Sales inMillionsTotal Vol.
48
44
2.01.51.0.5MAY11 18 25 1
JUNEAUGUSTJULYSEPTEMBEROCTOBER8 15 22 29 6 13 20 27 3 10 17 24 31 7 14 21 28 5 12 19
FIGURE 9. Daily closing price levels of the Dow–Jones Industrial and Rail Averagesfrom May 4 to October 19, 1946, and total daily market volume. This chart overlapsFigure 8. Compare the closing price of the Rail Average on June 13 with its February 5high close. This June action nullified the previous Dow Theory importance of theFebruary lows. Note significant change in volume pattern after May, especially during the August rally.
through their May–June Tops, the Major Bull Trend once again would bereaffirmed. But if they should now turn down and fall below the July 23closing levels, that action would signal a Reversal of the Primary Trend.
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The Bear Market SignalThat the situation was critical was evident in the volume chart. Ever sincethe end of May, turnover had tended not only to increase on the declinesbut, what was much more important, to dry up on the rallies. CompareFigure 9 with 7 and 8, and you can see how conspicuous this phenomenonhad become by mid-August. Prices did turn down, with activity increasingon the breaks, and on August 27, the closing prices, 191.04 for the Industrialsand 58.04 for the Rails, told a sad story. The Averages had spoken: a 4-yearBull Market had ended, and a Bear Market was under way. A Dow investorshould have sold all his stocks on the following day (at approximately190 and 58 in terms of the two Averages).To clear the record, it was necessary for the Dow theorist now to go backand mark the May 29 and June 13 highs in the Industrials and Rails, respectively, as the end of the Bull Market. The June–July decline then became thefirst Primary Swing in the new Bear Trend, and the July 23 to August 14advance became the first Secondary Recovery within the Major Downtrend.A second Primary Swing was now in process of development.You will have noted in the foregoing that a Bear Market was signaledas soon as both Averages penetrated their July 23 lows. Let us return nowand take up that argument which we mentioned on the preceding page.Some students of Dow Theory refused to recognize the new high of June 13in the Rail Average as a decisive reaffirmation of the Bull Trend. The previousclose should be bettered by at least a full point (1.00), many argued, in orderto confirm the signal previously given by the Industrials; the margin of only0.08 was inconclusive. But this opinion, if accepted, had logical consequenceswhich later proved embarrassing. For, if the Bull Market had not been reaffirmed in June, then the critical levels on the downside remained at 186.02in the Industrials and 60.53 in the Rails, the February 26 Bottoms. Therefore,a Bear Market could not be “called” until those prices had been penetrateddownside by both Averages. This view acquired a large following, especiallyamong those who were not interested in “hair splitting” theory but wanted “togive the market every chance in view of the still improving fundamentals.”The market did, of course, proceed to break its February lows, and bythat time, the Panic (second phase) was on. Obviously, in this case, theorthodox “any-penetration-whatever” school had all the best of it; they hadsold out at least 13 points higher up in terms of the Industrial Index (at least6 in the Rails). Six weeks later, on October 9, 1946, to be exact, this secondPrimary Intermediate Swing ended at Industrials 163.12, Rails 44.69, andanother Intermediate Recovery Move started.Before closing this history of 6 years of Dow Theory interpretation, wemight note that the June 13 high in the Rail Average furnishes a perfectillustration of the rule that a trend can change any time after it has beenconfirmed or reaffirmed, also of the diminishing odds in favor of continuancewith each successive reaffirmation of the Primary Trend.
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chapter five
The Dow Theory’s DefectsOur readers, we suspect, heaved a deep sigh of relief when they closed thepreceding chapter on a difficult, tedious, and, at times, confusing subject.Some may even wish at this point that the Dow Theory had never beenconceived. Others doubtless spotted one or more of its real or supposeddefects and have questions to ask. Before we proceed to more interestingchart matters, we had better devote a few pages to clearing them up.First, let’s take up the charge of “second guessing” which is so oftenflung at writers on Dow Theory. It is a charge which will continue to cropup so long as opinions differ among Dow theorists at critical periods (which,unfortunately, is often the case). Even the most experienced and careful Dowanalysts find it necessary occasionally to change their interpretations whena stand first ventured is rendered untenable by some subsequent action ofthe market. They would not attempt to deny it — but, they say, in the longrun, surprisingly little is lost by such temporary misinterpretations. Manyof them publish their comments regularly and can refer you to the printedfiles of opinions and advice expressed before and during the event, as wellas after it. As for the preceding chapter of this book, the reader, if he caresto check such records, will find that the interpretations given therein (asidefrom the remarks made “in retrospect” and so labeled) were precisely theinterpretations published at the time by the best established Dow analysts.EN9: While, in the modern age Richard Russell (dowtheoryletters.com) is probablysenior in terms of reputation, a host of other Dow Theorists (actually trying toround them up is like herding cats) inhabit the scene, among them Jack Schannep(thedowtheory.com) and Richard Moroney (dowtheory.com) who must be taken intoaccount when consulting the sacred-chicken bones. Robert W. Colby (robertwcolby.com) is currently doing interesting work in Dow Theory. Note that it is thechicken which is sacred, and the bones only secondarily.
The Dow Theory Is “Too Late”This is a more valid objection. It is sometimes expressed in the rather intemperate statement that “the Dow Theory is a sure fire system for deprivingthe investor of the first third and the last third of every Major Move, andsometimes there isn’t any middle third!” Or, to give a specific example:
41
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A Primary Bull Market started in 1942 with the Industrial Average at 92.92and ended in 1946 at 212.50, for a total gain of 119.58 Average points, butthe strict Dow theorists could not buy until the Industrials were up to 125.88and couldn’t sell until prices had already declined to 191.04, thus capturing,at best, only about 65 points, or not much more than half of the total move.This specific statement cannot be disputed. But the answer to the generalobjection is “Try and find a man who first bought his stocks at 92.92 (or evenwithin 5 points of that level) and stayed 100% long throughout the intervening years, and finally sold out at 212.50, or within 5 points thereof.” Thereader is welcome to try; he will, in fact, find it very difficult to locate evena dozen who did as well as the Dow Theory.A still better answer, since it comprehends all of the hazards of everyknown kind of Bull and Bear Market to date, is the overall dollars and centsrecord of the past 60 years. We are indebted to Richard Durant for permissionto reprint the following computation of what would, in theory, have resultedif a fund of only $100 could have been invested in the stocks of theDow–Jones Industrial Average on July 12, 1897, when a Primary Bull Marketwas signaled by the Dow Theory, and those stocks were thereafter sold andrepurchased when, and only when, the Dow Theory had definitely confirmed a change in the Major Trend (see Table 1).In brief, an investment of $100 in 1897 would have become $11,236.65in 1956 simply by buying the Industrial Average stocks each time the DowTheory announced a Bull Market and holding them until the Dow Theoryannounced a Bear Market. During this period, the investor would have made15 purchases and 15 sales, or about 1 transaction every 2 years on average.The record is not perfect. It shows one losing transaction and threeinstances where reinvestment would have been made at a higher level thanthe preceding liquidation. But, at that, it hardly needs defending! Also, ittakes no account of commissions and transfer taxes, but neither does itinclude the dividends the investor would have received during the time heheld his stocks; the latter would, needless to say, have added many moredollars to the fund.For the enlightenment of the man who believes in “just buying goodstocks and putting them away,” compare the above results with the best thatcould have been done by buying shares only once at the lowest pricerecorded by the Industrial Average during these entire 50 years and sellingthem only once at the highest. $100 invested at the all-time low, 29.64 onAugust 10, 1896, would have become only $1,757.93 at the all-time high,521.05, 60 years later on