a strongindicator of the U.S. economy and business climate.1The DJIA is a weighted average, meaning that as companies onthe list grow and split their stock, the weighting changes. Over time,those stocks with higher share prices carry a higher weighting factorthan stocks whose share price is smaller. The DJIA is called a priceweighted index because expensive shares have more inﬂuence on thetrend than cheaper shares. Ironically, this has nothing to do withactual capitalization. The share price is merely the current marketvalue per share. Does this mean that a company with a $100 stockis ‘‘better’’ than one with an $80 stock? No. If the $100 stock’scompany has 5 million shares, total capital value is $500 million. Ifthe company with the $80 stock has 10 million shares outstanding,its total capital value is $800 million.The disparity created by a price-weighted index is considerable.For every point of inﬂuence a $100 stock has on movement of theDJIA, an $80 stock has only 0.8 points of weighting and a $50 stockhas only 0.5 points.Some indices are market value–weighted, a system much different than the DJIA. In these indices, the value of each componentstock is weighted based on total capital. Returning to the previousexample, a $100 stock whose company has $500 million in capital
The ‘‘Practical’’ Dow Theory
67
would be much different than an $80 stock with $800 million incapital. For every point of weighting in the $800 million company,the $500 million company would carry ﬁve-eighths the point valuein the index.The impact of a price change is where this makes a difference.In a price-weighted stock, the higher-priced issues will have correspondingly greater inﬂuence on movement of the average. In a capital value–weighted index, inﬂuence depends on the overall value ofthe company.Some well-known market value–weighted indices include theNASDAQ Composite Index, the NYSE Composite Index, and theS&P 500. The S&P 500 has modiﬁed its weighted method and isnot ‘‘ﬂoat-weighted.’’ This means that only shares available for publictrading are counted in the weighting. This is a subtle distinction, butthe problem of market analysis remains: Daily ﬁnancial news programs like to report on movement in the DJIA, the NASDAQ, andthe S&P. But in fact, these three indices are all computed in differentways: price-weighted, market-weighted, and ﬂoat-weighted.Most people continue to judge the market by the DJIA. Withoutany doubt, current trends and strength or weakness in this widelyfollowed index are good indicators of overall market conditions.The distinctions between bull and bear markets are deﬁned largelyby how the DJIA moves or fails to move. A summary of the 30 stocksin the DJIA and their weighting as of late February 2008 is providedin Table 4-1.The higher-priced stocks on the DJIA have the greatest inﬂuence, as this table reveals. At the time of these weighting factors(October 2007), ﬁve stocks [3M (MMM), Boeing, (BA), Chevron(CVX), Exxon-Mobil, and IBM] held over 29 percent of the totalweighting of the DJIA. This is signiﬁcant. These higher-pricedstocks and their fortunes on the market may actually distort theconditions in the broader market for some relatively isolated events.For example, say that Exxon-Mobil’s stock rose many points following the rising price of oil, and at the same time Boeing received newcontracts for dozens of planes while IBM and 3M also reached newagreements expanding their market share. It is conceivable that theDJIA could rise signiﬁcantly even if other components were weak
68
Winning with Stocks
TAB L E 4 - 1 . D O W J O N E S I N D U S T R I A L AV E R A G E C O M P O N E N T S
Company
Weighting %
Company
Weighting %
3MAlcoaAmerican ExpressAIGAT&T
5.16%2.502.963.352.26
Hewlett-PackardHome DepotIntelIBMJohnson & Johnson
3.14%1.861.337.474.04
Bank of AmericaBoeingCaterpillarChevronCitigroup
2.75%5.384.765.661.65
JPMorgan ChaseMcDonaldsMerckMicrosoftPﬁzer
2.85%3.552.921.811.46
Coca-ColaE.I. DuPontExxon-MobilGeneral ElectricGeneral Motors
3.85%3.055.732.181.59
Proctor & GambleUnited TechnologiesVerizonWal-MartWalt Disney
4.31%4.682.333.302.12
Total
100.00%
Source: Dow Jones & Co., as of February 26, 2007 rounded down
and the overall market were in poor condition. The likelihood ofsuch distortions occurring chronically is small. These companiesare in different industries and are internationally diversiﬁed, so economic impacts of any signiﬁcance are likely to be mirrored amongthe entire market, but the issue is worth being aware of. The 30industrials carry a lot of inﬂuence through the DJIA, and relativelyfew companies in the 30—four, in fact—account for nearly onefourth of the total DJIA movement.
The History of the Dow TheoryIt is interesting to trace back and see where the DJIA came from,and how it has become such an inﬂuential market indicator today.
The ‘‘Practical’’ Dow Theory
69
The origin goes back more than 125 years to 1882 when CharlesDow and his partner, Edward Jones, formed Dow Jones & Company.In 1880, Charles Dow, a 29-year-old business writer with onlya limited formal education, arrived in New York after working forseveral years as a ﬁnancial writer in Providence, Rhode Island.While in Rhode Island, Dow met fellow ﬁnancial writer EdwardJones when the two worked together at the Providence EveningPress. Dow was asked by his New York employer to recommend asecond reporter; thus Dow brought Jones into the Kiernan WallStreet Financial News Bureau. Two years later Dow and Jonesstarted their famous ﬁnancial organization, originally located in thebasement of a candy store. A year after that, they began publishingthe Customers’ Afternoon Letter, a two-page summary of each day’simportant ﬁnancial news and reports. They also devised an indexcalled the Dow Jones Stock Average, which included 11 companies(nine railroads, one steamship company, and Western Union). OnJuly 8, 1889, the two-page report evolved into the ﬁrst edition ofThe Wall Street Journal (originally available for two cents per issue).One of the big problems in those days, many years before federal regulation, was a tendency for companies to pay for favorablepress stories. Dow forbade his reporters from the practice of exchanging favorable stories for stock tips and began a new procedure: publishing the names of companies that refused to provideproﬁt and loss information for publication. These high ethical standards quickly earned the new paper a great deal of respect and a lotof power and inﬂuence on Wall Street.On May 26, 1896, Dow published a new average of 12 stocks.Dow simply added their prices together and then divided by 12 (toarrive at the average). The following year the paper added a railroadaverage. Most important among Dow’s innovations was his development of what is today called the Dow Theory. Dow saw a clearrelationship between trends in stock prices and other businesstrends. He thought that whenever his industrial and railroad averages were moving in the same direction, it was a signiﬁcant sign.Dow did not envision applying this trend analysis to the overallmarket, at least not as a primary way of judging stocks. His observa-
70
Winning with Stocks
tions were based on analysis of corporate internal trends in revenues, costs, expenses, and proﬁts and how those trends translatedto changes in stock prices. He also noted that stocks tended to movein predictable cycles tied to economic and industrial trends, whichalso were reﬂected in market activity. Dow’s original concept foundapplication in internal business practices. It was only after his deaththat Dow Jones & Company began applying Dow’s original observations to market-wide trends. They developed the Dow Theory byformalizing a series of observations originally noted by Dow himself.The averages produced by Dow provided market observers witha methodology for deciding whether a market trend was up ordown. By combining stocks together into a single index, the direction and strength were easily implied. Dow further believed that industrial and railroad average trends could serve to conﬁrm anevolving direction within the market. By 1896, the railroad average(renamed the transportation average in 1970) was increased to 20stocks and many years later, in 1929, the company added the utilityaverage.In 1926, the size of the industrial average was increased to 30issues, where it has remained ever since. That same year, themethod of calculation was adjusted to avoid distortions when companies split their stocks, which ultimately led to today’s priceweighted method. Today, the DJIA is the most widely cited index,and in most circles it is considered the primary measurement ofmarket strength or weakness.The term ‘‘Dow Theory’’ was ﬁrst used by S.A. Nelson in his1903 book, The ABC of Stock Speculation. In his book (he refers to‘‘Dow’s Theory’’ and devotes 15 chapters to the concept), Nelsonsummarizes Dow’s writings into a cogent single theory that couldbe applied against the entire market to spot trends and judge current conditions. Using Dow’s editorials from the preceding 20years, Nelson created a technical market theory that dominates themarket today.In fact, the Dow Theory has survived through more than 100years of change. As one writer observed in 1963,
The ‘‘Practical’’ Dow Theory
71
Dow’s basic principles have continued to function effectively in the morethan 60 years since his death and throughout a period which has encompassed both the horse-and-buggy and the space ages; two worldwars; the ascendancy of communism throughout the world; the vastchanges in political, social, and economic philosophies both at homeand abroad . . .2
Guiding Principles: Major Trends and ConﬁrmationsThe Dow Theory determines whether markets can be deﬁned asoptimistic and up-trending (bull market) or pessimistic and downtrending (bear market). The theory as it is applied today containssix speciﬁc tenets, or rules:1. Markets contain three trends. The three trends are wellknown. An uptrend occurs when two things take place. Prices closeat a higher level than before while low price levels in the same periodare higher with each rally (higher highs and higher lows). A downtrend is characterized by lower-closing low prices offset by lowerhigh prices in each subsequent rally (lower lows and lower highs).The third trend involves a clear direction and then a period of pricemovement in the opposite direction, ending with a return to theestablished trend.2. Trends contain three distinct phases. The Dow Theory alsodivides a trend into three segments. First is the accumulation phase,in which knowledgeable investors buy (in an uptrend) or sell (in adowntrend), often when the market-wide opinion is in the oppositedirection. Second is the public participation phase, in which a largersegment of investors recognizes the trend and follows it, often leading to higher volume and speculation. (The ‘‘crowd’’ usually followsthe trend, buying at or near the high and selling at or near the low.)Third is the distribution phase, in which wise investors distributetheir shares to the market (selling long positions or buying to closeshorts).
72
Winning with Stocks
3. All news and information is discounted by the stock market.Market prices are believed to absorb all news quite rapidly, even inanticipation of what has not yet been announced. For example, if anearnings report is due on Friday and most people think it will beatanalysts’ estimates, then on Wednesday and Thursday prices arelikely to rise in anticipation of the good news. Bad news is similarlytaken into the price and discounted in the current price levels andtrends. This ‘‘efﬁciency’’ is assumed and has been expanded into the‘‘efﬁcient market hypothesis’’ (see the next section for more aboutthis).4. Market averages must conﬁrm one another before a new trendcan be called. Dow believed that railroads were essential to economic conditions because goods had to be shipped from manufacturer to market. This interdependency meant that industrial growthhad to be accompanied by a similar pattern in the rails (transportation stocks). This logical observation led to the theory of conﬁrmation. When two averages begin moving in the same direction, itsignals a new trend; once one of those averages begins to diverge, itanticipates a change in the trend.5. Price trends are conﬁrmed by volume of trading. When pricechange happens on low trading volume, it could be caused by anynumber of external forces, such as short covering or takeover rumors. But whenever price change is accompanied by high volume,it serves as further conﬁrmation that the trend is real.6. Trends continue until subsequent signals prove that they haveended and new trends have begun. This is perhaps the most important of the Dow Theory tenets. From day to day, it is very difﬁcultto read the trend because prices move up and down, often in veryvolatile change patterns. A trend is not actually ended and reverseduntil the signals are there to conﬁrm (phase changes, conﬁrmation,and volume).Not everyone agrees with or accepts the Dow Theory as the lastword. It has always been controversial and, like all theories, it is notperfect. Depending on the time period studied, the Dow Theorymay beat the more traditional ‘‘buy-and-hold’’ approach so popular
The ‘‘Practical’’ Dow Theory
73
among value investors (that is, ﬁnd bargain-priced stocks for exceptionally well-managed companies, then buy and hold for the longterm). A study published in 1933 concluded that buy and hold produced a 15.5 percent return versus the Dow Theory strategy’s 12percent, during the period 1902–1929.3That study was also controversial and possibly inaccurate. Theabsolute returns of the buy-and-hold approach cannot be comparedto the risk-adjusted returns possible by moving in and out of issuesbased on Dow Theory indicators. Market timing strategies may behigher risk but may produce potentially greater rates of return. Theonly reasonable conclusion is that any theory is going to work wellin times when the trends play out according to what the theory anticipates, and when that does not happen, the same theory appearsless reliable. The Dow Theory is not the only technical approach,however. Two additional ideas also ﬁnd their own followers. Theseare the random walk theory and the efﬁcient market hypothesis.Even with its controversial interpretations, the Dow Theory isfascinating and useful in judging market conditions. Without indices and methods for taking the stock market’s temperature, investors would never know where matters stand. If you listen toeconomic data published by the government, you know that economic indicators are often contradictory or have little immediateimpact on stock market conditions; so relying on these data is notsatisfactory for most people. The Dow Theory and indices like theDJIA, the S&P 500, and the NASDAQ all help to place a conditionalvalue on the market at any given moment in the day, or within alarger, longer-term trend.
Alternative Technical TheoriesThe Dow Theory has certainly stood the test of time. Given theincredible changes in technology during the past century, this isquite amazing. In the days when Charles Dow was writing his essaysconcerning business trends, there were no airplanes, freeways, orcomputers. Most people lived on farms and never traveled morethan 20 miles from their places of birth. Only insiders were able to
74
Winning with Stocks
participate in markets for the most part, and anyone who wanted toinvest had to rely on brokers, whose activities were not regulated byeither federal or state governments.However, the Dow Theory is not the sole technical approach tothe stock market. It does establish a methodical process for makingconsistent judgments about whether the overall economic mood ispositive or negative, but some market observers contend that thisapproach is not the only way to look at the market. Two additionalbeliefs, the random walk theory and the efﬁcient market hypothesis,should be considered as well.The random walk theory contends that it is impossible to predictmarket movements. Academic tests involving picking stocks withcoin ﬂips appear to support the idea that there is a 50/50 chance ofa stock’s rising or falling, but this ignores the qualifying reasons forsuch changes. Of course there is a 50/50 chance of movement, andthere are only two directions possible other than a no-change outcome. But both technical and fundamental reasons have much moreto do with how stock prices change than actual randomness. If youtry to apply the random walk theory to any other supply-anddemand market, its ﬂaws become obvious very quickly.For example, what if someone told you that there was a 50/50chance that housing prices would rise or fall? Historically, housingprices in robust economic markets rise over time. By ‘‘robust,’’ thismeans strong job growth, moderate to low crime levels, and otherdesirable attributes. As long as jobs are growing and people are safe,housing values will rise. More people want to move to nice areas,which places pressure on prices. Supply and demand is an obviousforce economically speaking, so housing prices rise. People need aplace to live, and as they can afford to buy homes rather than renting, this theory makes sense in many ways. There may be such phenomena as housing bubbles, overpricing, and actual declines invalue in some areas, but in most situations housing values rise predictably. There is nothing random about it.The argument using the housing market makes sense, especiallywhen you recognize that predictability of future value is a factorof clearly understood economic drivers: jobs, tax beneﬁts, climate,quality of life, crime levels, ease of commute, and social and recre-
75
The ‘‘Practical’’ Dow Theory
ational outlets. The attributes that cause housing prices to rise consistently over time are sensible and widely understood.The same concept applies to the stock market, disputing therandom walk theory in virtually every case. As an academic theory,it is interesting and worthy of discussion but it simply does not workout. Consider the comparisons between stocks with technical andfundamental attributes as summarized in Table 4-2.The differences between stocks with these basic attributes areglaring. It is not only reasonable to assume that these attributes determine future price direction; it is inevitable. Stocks with strongtechnical and fundamental outcomes do increase in value, just asTABLE 4-2. STOCK COMPARISONS
Positive Attributes
Negative Attributes
Technical Analysis:narrow trading range moves upwardover time
volatile trading range withunpredictable direction or trend
gradual price growth over manyyears
gradual price decline over manyyears
P/E ratio between 10 and 25
P/E ratio between 60 and 110
Fundamental Analysis:current ratio of 2 to 1
current ratio of 1 to 3
debt ratio between zero and 25%and remaining the same over manyyears
debt ratio between 50% and 75%and increasing each year
dividend above 4%
dividend between zero and 1%
dividend has increased every yearfor 10 years or more
dividend has not increased or somedividends have been skipped
sales and earnings increase everyyear
sales grow but earnings fall
net earnings and core earnings areclose together with only minoradjustments
big adjustments occur every yearbetween net and core earnings
76
Winning with Stocks
those with deteriorating attributes tend to reﬂect a negative pricetrend. The random walk theory is an interesting academic exercise,but it is easily disputed.The efﬁcient market hypothesis is an outgrowth of the Dow Theory, which observes that all news is discounted in the current price.In fact, the concept that the market is efﬁcient supports the randomwalk theory in some respects. If the market were efﬁcient, meaningthat the current price reﬂects all known news and information, thenfuture price movement might be truly random. But like the randomwalk theory, the efﬁcient market hypothesis is clearly ﬂawed andfalse.In fact, the market is highly inefﬁcient. You consistently seeprice changes overreacting to news and information as it is released.When analysts estimate earnings of $5.02 per share and actualearnings come in at $5.01, the stock may fall several points. It doesnot matter that the earnings are the best ever, or that the companymaking the report is very pleased with the outcome. All that mattersis that the report was ‘‘disappointing’’ because it was one penny pershare lower than the estimates. This is unrealistic.By the same argument, stocks may increase unreasonably. In2007, Microsoft stock rose by ﬁve points, or about 12 percent, inone day (October 26) following $4.3 billion net income in the latestquarter versus $3.5 billion the year before. Microsoft is an excellentcompany with nice proﬁt margins and no long-term debt, but it isextremely unusual for a large-cap company to experience a one-dayspike in stock price above 10 percent. This is a case of the marketoverreacting to news. Even though it was good news, the jump inprice is an oddity. Such momentary changes, usually followed bycorrections later the same day or the next day, are not at all uncommon.The market is anything but efﬁcient. It overreacts to virtually allchanges, positive and negative. The ﬂuctuations in price from moment to moment reﬂect ever-moving interaction between buyersand sellers, short-selling and covering of positions, poorly timedlong positions being opened and closed, and self-serving timing decisions by large mutual funds. None of these market forces are byany means efﬁcient. Anyone with money in the market knows—
The ‘‘Practical’’ Dow Theory
77
often painfully—that the efﬁcient market hypothesis is an interesting theory but far from practical.Both random walk theory and efﬁcient market hypothesis arepopular beliefs in academic circles, because they are comforting tothose who choose to believe in them. Most of the people who subscribe to these beliefs do not have real money at risk in the market,however, but function in the academic world only. This is a harshindictment of both technical beliefs; however, they do serve a purpose. The proposition that the market and its pricing is somehowout of the hands of investors raises issues worthy of discussion. Thisleads to greater diligence in identifying the technical and fundamental attributes of stocks that make it possible to pick stocks in a nonrandom manner, and to cope with the inherent inefﬁciency of themarket. In fact, the nonrandom nature of the market points the wayto picking stocks well, and the inefﬁciency (even irrationality) alsoprovides proﬁt opportunities. Because the market is ruled by emotions such as greed and fear, those who keep a cooler head and areable to work against a crowd mentality are likely to time their decisions better than the average investor.This idea—buying when most people are in a panic and selling,or selling when everyone else is in a euphoric state of greed andbuying—is called contrarian investing. Many people have noticedthat there is a tendency to ‘‘buy high and sell low’’ instead of theother way around. The ‘‘crowd’’ operates on greed and fear, andthat means that a contrarian can go against the ﬂow, and ratherthan following the crowd, makes contrary decisions. This meansselling when the ‘‘conventional wisdom’’ says ‘‘buy, buy, buy’’ andbuying when everyone else is in a panic and believes that the marketis about to crash.Contrarians are more likely to proﬁt in the market because theytake proﬁts at or near the top and buy bargains at or near the bottom. The success of the contrarian approach demonstrates the falsepremise of both random walk theory and efﬁcient market hypothesis. It is a philosophy of investing that observes a fact: ‘‘Bulls andbears can both make a proﬁt in the market, but pigs and chickenscannot.’’
78
Winning with Stocks
The Problem for Portfolio Analysis: ApplyingTechnical TheoriesMany technical theories are based on broad index analysis. This iswhy the DJIA is such a popular indicator. It tells you whether themarket is up or down. But when it comes to individual stocks, doesthe DJIA actually help?Application of any index is going to be broad, so it can onlyprovide you with a general indicator of the market’s health at themoment. When it comes to picking stocks, you need some stockspeciﬁc indicators, whether technical or fundamental.Many stocks follow index direction, so it would be unrealistic todiscount the value of the DJIA, the S&P 500, and the NASDAQ.They provide valuable insights and are ﬁne as starting points. Obviously, people are more likely to want to get into the market whenthe direction is upward, when enthusiasm is visible, and when pricesare rising across a broad spectrum. But picking a speciﬁc stock requires the use of more directed tests. The decision to buy, hold, orsell a speciﬁc stock cannot be tied to the DJIA.As Charles Dow observed more than a century ago, trends meansomething. If you see a trend in an individual stock, it is there for areason. There is nothing magical or mysterious about how or whyprices change; the reasons can always be found and once you seehow the cause and effect works, it becomes easier to make marketdecisions in the future. By the time a trend turns and begins movingin the opposite direction, it is too late to make decisions. It is criticalto develop a system for studying stock trends that anticipates whatis going to happen. Timing a buy or sell decision based on trends asthey occur is a far more sensible and proﬁtable system than tryingto react after a trend has ended. Hindsight is valuable, but it rarelyleads to proﬁts.Making predictions is always elusive, but good predictions arepossible, especially concerning high-quality stocks in well-managedcompanies. For example, Microsoft is clearly a leader in its industry.The stock has a history of trading in a narrow range but movingrelentlessly upward over many years. The company carries no debtand it produces a high-quality product. They have had their share of
The ‘‘Practical’’ Dow Theory
79
problems, but sector leaders are always big targets for competitors.Microsoft has been sued endlessly over its entire history, but theproduct quality is indisputable and the stock’s history proves onebasic truth about the market: Well-managed companies reward theirstockholders.The same observation works in the opposite direction. GeneralMotors, one of the best examples of a company that has literallybeen run into the ground over several decades, reported growingrevenues with shrinking net proﬁts, and massive core earnings adjustments. Its debt is greater than 100 percent of equity capitalization. Its pension liabilities (which don’t show up on the balancesheet) are higher than the company’s total net worth. And, not surprisingly, the stock price has fallen drastically over many years. In1997, GM stock traded between $72 and $52 per share. In 2006, ittraded between $37 and $18. The reason: ever-falling net proﬁtsand rising debt, and perhaps most importantly of all, a decliningproﬁtability ratio. Revenues rose every year in that decade, whileproﬁts plummeted.There is nothing random in the GM fundamental or technicalhistory, and the same can be said about Microsoft. They are goodexamples of how poorly managed companies fail to compete in aglobal market (GM versus Honda [HMC] and Toyota [TM], forexample), and how well-managed companies only get better overtime (Microsoft as a global leader in its industry, for example).Realistically, you need to study and understand the various market theories and then simply place them in perspective. The DowTheory has stood the test of time even in a rapidly changing worldbecause it makes sense and has been proven useful in understandingthe stock market. The random walk theory and efﬁcient market hypothesis are interesting concepts for discussion, but only to the extent that they demonstrate the importance of analysis, bothtechnical and fundamental. These two theories are cynical becausethey imply that as investors, people have no way of controlling theirown destinies. Both theories tell you that the market is random andcompletely chance, or that prices are so efﬁcient that you can neverﬁnd bargains. These beliefs are false and the real truth—that you
80
Winning with Stocks
can ﬁnd quality investments through analysis and study—is farmore reassuring.
Applying the Dow Theory to Individual StocksThe problem with the Dow Theory as it is used today is that it isusually considered a market-wide indicator. It provides no guidancein the timing of buy and sell decisions for individual stocks. However, the precepts in the Dow Theory can be used to help makedecisions in a timely manner for each stock.No stock is going to follow the broader market exactly, so youcan apply Dow Theory tenets to individual stocks and gain insight.It is a useful exercise to review each of the six observations in theDow Theory as they can be applied to buying and selling individualstocks rather than judging the direction of the overall market. Thesix points:1. Markets contain three trends. The uptrend, downtrend, andtemporary reversal trend apply to all market-wide movements. Theyalso apply to speciﬁc stocks. In fact, for traders who want to movein and out of stocks in the short term rather than holding shares formany years, observation of trends is a valuable method for timingbuy and sell moves. Day traders (those who move in and out ofpositions within a single trading day) and swing traders (those whocomplete transactions usually within three to ﬁve days) use thesetrends as their primary tools. Under swing trading deﬁnitions, anytrend of three or more changes creates a setup. An uptrend consistsof three or more consecutive periods in which each subsequenttrading range has higher highs offset by higher lows. A downtrendconsists of three or more consecutive periods in which each subsequent trading range has lower lows offset by lower highs. A setup isfound when these trends end. After three or more downward movements, a ‘‘buy’’ is signaled. After three or more upward movements,a ‘‘sell’’ is signaled.2. Trends contain three distinct phases. Accumulation, publicparticipation, and distribution apply to speciﬁc stocks as well as to
The ‘‘Practical’’ Dow Theory
81
overall markets. Wise investors accumulate positions before themarket crowd does so. Public participation happens once the‘‘crowd’’ recognizes the trend and gets in. Distribution is when thepositions are closed at the end of the trend. The classic contrariansequences involve buying shares when the stock is out of favor (accumulation), enjoying the beneﬁts of the price being driven up whenthe crowd enters the stock (public participation), and selling at ornear the high and in advance of a reversal (distribution). The samesequence can be applied by short sellers in the sequence of sell, hold,and buy to close.3. All news and information is discounted by the stock market.Every stock’s price is affected not only by news and events, but inanticipation of pending information. When a company is going toannounce earnings on Friday, the stock is going to move on Monday through Thursday. If the widespread belief is that the stock willbeat analysts’ expectations, the price will be driven up. If the opposite expectation dominates, the price will decline. When the outcome is greater than expected in either direction, the price adjustsoften violently due to the surprise factor. The market hates surprises, so it invariably overreacts when they pop up.4. Market averages must conﬁrm