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A Dow Theory

Mukul Pal · March 27, 2009

dowcycles
The generational theory can be refined by understanding the significance of TIME
Charles Dow wrote ideas explaining the movement of the Dow Index (DJI). Robert Rhea compiled them and called it ‘The Dow Theory’. A majority of market theories and tools have come after that. The theory still makes the introductory pages of any basic technical analysis book after 125 years. Though we have studied it as a student and quoted it with reverence, we want to challenge it today.
This is not because the theory is any less profound or we have stopped looking up to it, but time refines everything, even historical theories. I don’t know how Charles Dow would have reacted to this article. The humble Wall Street editor who never used to get angry taught us everything we know today. He changed the world.
We are a trend focused society with our economic, fundamental, behavioral, cultural, statistical and scientific trends. The Dow Theory also talked about trends. Trend is what we technicians are taught to identify, to ride and get off before reversal, or to ride it down as a sharp shooter. Trend means bias, uptrend is a positive bias and down trend is a negative bias. Dow’s simple theory gave form to this bias.
He said that markets move in stages, accumulation, speculation and distribution stage. He gave market a three stage form, characterizing three degrees of price trends, a primary, secondary and minor (noise). There are clear tenets he defined in his work. Fig. 1 shows some illustrative examples how Dow’s observation of three stages was a clear observable pattern.
The first tenet of the Dow Theory is that prices discount all information and expectations, to the point that they are predictive of events. If information was supposed to be assumed by price and information has a positive and negative bias, one could assume that the theory studies the bias in price, which forms a three legged structure. Fundamentalists say that information (the cause) affects the price (gives it the bias). Bias measurement is tough, but the theory laid down a solid framework to interpret it. There is a large bias, small bias and smallest or unseen bias. The very fact that prices trend for years, also suggest a polarity in bias. However, the theory despite its simplicity and workability has come under criticism of being late.
The late part is what we would like to address here. Why is the theory late in telling us that the Dow is reversing? Why there was clear tenet in the theory saying that trends exist until definitive signals prove that they have ended? Why did Dow want to give the trend a benefit of doubt during reversals? The reason for such confusion was because unknowingly Charles Dow was studying time. It’s just that he did not realize it. Fig.1 illustrates the same three stages structures, but with unbiased time cycles underneath it. The cycles illustrate time not the bias in price. There are three time cycles defining every three stages in DJI structure. The reason the theory was late or slow was because the price bias was out of sync with time, delayed. In some cases the bias was too large to understand (200-2009) and sometime minimal (1970-1982). Since 1965 there has been average fixed time cyclicality.
Aristotle said the earth was stationary, Newton said it moved, Einstein came and said that the stationary and the moving status depended on the reference frame you looked at it from. Einstein’s relativity theorem explained time. Einstein could do it because he started looking at relative motion. Even Dow did this as he talked about relative movement of one index to another. What he was doing was unknowingly detrending, discounting bias and understanding time. One of the theory’s tenet said that relative movement of the railroad indices against DJI explained the status of the trend on the Index, whether it was ready to reverse or not. Here again, Dow was focused on the trend of two indices and not the time. If both of the indices make higher highs, trend is in place, if not the trend is under question and could reverse.
Can the new railroads, the Dow Jones Transports (DJT) ever secularly outperform Dow Industrials? No. There is no Dow Transports without Dow Industrials. This means that DJT best performance is when it reaches parity with DJI’s average performance. What does it means in terms of trend? Transports have a limit of outperformance against the DJI. When it reaches there, the worst of DJI weakness is over. And the blue chip index should rise not only against DJT but also reverse the ongoing trend.
In Fig.2 we have illustrated the DJI (in price bars) along with the relative cycle line between DJI and DJT. The movement of the underlying cycle suggests that whenever Industrials reached an extreme performance against Transports (point F, G) DJI topped and vice versa. A simple relative cycle, timed the two historical tops of DJI in 2000 and 2008.The current status of the cycle also suggests now that DJT out performance is reaching a historical high against DJI suggesting that 2009 should witness a multi month reversal in DJI.
transportsvsdji
There are various other tenets of the theory which we can systematically be challenged. They all point to the same thing. One; the theory was generational because it was partially in sync with time. Second; the reason the theory was late was because it focused more on understanding the price bias and not the underlying time. Third; the idea of lower low or higher high in confirmation is a crude tool to understand time. Relative cycles are the real tool, objective and unbiased.
Fundamentalists and Technicians debate a lot about cause and effect. One says it studies the cause, while the other claims to study the final effect, the price. The debate made sense till the time there were many causes affecting the price. The debate ceases to exist when time becomes the only cause. Till we start focusing on time, indicator failure will remain a reality and life will look random. Predictability is about time, accepting or not accepting it is something else.

THE DOLLAR CYCLES
Armonia triunghiulara

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