Doubts about Dow

While much of what Dow wrote can be recognized in some form in modern-day technical analysis, it has inevitably been criticized in the light of later thinking. Considering that Charles Dow made his observations more than 100 years ago, it perhaps should be considered more astonishing that so much of his work is still recognizable in modern times.

The first point is that Dow relied on closing prices only. He used a simple line chart, such as I’ve included here to illustrate the principles, and only based his interpretation of the trends on these values. You will see in the next module, on charting, that we do have more information than that, which can help us interpret the mood of the market. As prices can vary significantly during the day, or ‘intraday’, this can affect the accuracy of the trends.

Secondly, by the time that Dow’s criteria have indicated a bull or bear market, possibly a quarter or a third of the price move may already have happened. Usually the confirmed signal will be in the second phase of the trend. This is no worse than many trend following systems, but obviously the trader would like to improve on it to increase potential profits.

Another point is that the averages such as Dow used are not much use to shorter term investors who seek to profit in less than a year. The Dow Theory, at its core, provides analysis and explanation of the market movements over a 2 to 3 year period. While the concepts are useful in developing technical analysis tools, the tenets of the theory relate more to an investing rather than trading timescale.

Problems with Elliot Wave Theory

Perhaps the most important lesson to be taken from the Dow Theory is that Dow looked at what is happening in the markets, rather than what ‘should be’. His tenets were based on his observations. Many a beginning trader has cried ‘Foul!’ when a stock price has moved in the opposite direction to where it ‘ought to’ by a process of reason. The markets will do what they want, and have no knowledge of reasonable expectations. It is up to the trader to interpret what is actually happening in order to gain an indication of the future.

The principles that Dow put forth are still talked about by traders. If you know them, you have very sound basis from which to develop and learn more about technical analysis. There is nothing controversial here, but learning them is a good start to your trading education.

The Dow Jones Industrial Average has been maintained by the editors of the Wall Street Journal to this day. It now comprises 30 companies, a number which it increased to in 1928. Only one has been in the average since its inception, and that is the bellwether stock called General Electric. Although the average was comprised solely of stocks traded on the New York Stock Exchange for many years, in 1999 the index accepted two stocks from the NASDAQ exchange, IBM and Intel, to allow the average to give some reflection of the role of technology in society.

It is only after careful consideration that the editors of the Wall Street Journal substitute different stocks into the DJIA, and weightings are applied to maintain the overall index value. Despite the fact that only 30 stocks are used in the calculation, it has a reputation for reacting well to changes in the economy. Other indices, such as the Standard & Poor’s 500 and the FTSE 100, have many more companies represented.

Summary

  • Technical analysis is based on market action, which is price and volume – and includes open interest too with futures and options.
  • The markets discount everything, reflecting all there is to know about the price.
  • The markets exhibit trends which can be identified.
  • History repeats itself, so you can expect the same outcomes from same circumstances.
  • The Dow Theory states that there are three types of price movement in a trend, and that the primary movement has three phases.
  • The industrial and transport averages must agree on a trend to validate it.
  • Volume increases in the direction of a trend, to confirm the trend.
  • Trends continue until a clear reversal.

At the end of each module there is a quiz. You can take a quiz at any point, but we suggest you view each module before taking the quiz. When you’re ready to start the quiz, click the take quiz ‘Start’ button below -:

The Masters Certificate in Technical Analysis - Module 1

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