The Dow Jones Theory is probably the most popular theory regarding the behavior of stock market prices. The Dow Jones theory has been around for almost 100 years, yet even in today’s volatile and technology-driven markets, the basic components of this theory still remain valid. The theory derives its name from Charles H. Dow, who established the Dow Jones & Co. and was the first editor of the Wall Street Journal – a leading publication on financial and economic matters in the U.S.A. Although Dow never gave a proper shape to the theory, ideas have been expanded and articulated by many of his successors.
The Dow Jones theory classifies the movement of the prices on the share market into three major categories:
- Primary Movements,
- Secondary Movements and
- Daily Fluctuations.
1) Primary Movements: They reflect the trend of the stock market and last from one year to three years, or sometimes even more. If the long range behavior of market prices is seen, it will be observed that the share markets go through definite phases where the prices are consistently rising or falling. These phases are known as bull and bear phases.
During a bull phase, the basic trend is that of rise in prices. Graph 1 above shows the behavior of stock market prices in bull phase.
You would notice from the graph that although the prices fall after each rise, the basic trend is that of rising prices. As can be seen from the graph that each trough prices reach, is at a higher level than the earlier one. Similarly, each peak that the prices reach is on a higher level than the earlier one. Thus P2 is higher than P1 and T2 is higher than T1. This means that prices do not rise consistently even in a bull phase. They rise for some time and after each rise, they fall. However, the falls are of a lower magnitude then earlier. As a result, prices reach higher levels with each rise.
Once the prices have risen very high, the bear phase in bound to start i.e., price will start falling. Graph 2 shows the typical behavior of prices on the stock exchange in the case of a Bear phase. It would be seen that prices are not falling consistently and, after each fall, there is a rise in prices. However, the rise is not much as to take the prices higher than the previous peak. It means that each peak and trough is now lower than the previous peak and trough.
The theory argues that primary movements indicate basic trends in the market. It states that if cyclical swings of stock market prices indices are successively higher, the market trend is up and there is a bull market. On the contrary, if successive highs and low are successively lower, the market is on a downward trend and we are in bear market. This theory thus relies upon a behavior of the indices of share market prices in perceiving the trend in the market.
2) Secondary Movements: We have seen that even when the primary trend is upward, there are also downward movements of prices. Similarly, even where the primary trend is downward, there is upward movement of prices also. These movements are known as secondary movements and are shorter in duration and are opposite in direction to the primary movements. These movements normally last from three weeks to three months and retrace 1/3 to 2/3 of the previous advance in a bull market of previous fall in the bear market.
3) Daily Movements: There are irregular fluctuations which occur every day in the market. These fluctuations are without any definite trend. Thus is the daily share market price index for a few months are plotted on the graph it will show both upward and downward fluctuations. These fluctuations are the result of speculative factor. An investment manger really is not interested in the short run fluctuations in share prices since he is not a speculator. It may be reiterated that anyone who tries to gain from short run fluctuations in the stock market, can make money only be sheer chance. The investment manager should scrupulously keep away from the daily fluctuations of the market. He is not a speculator and should always resist the temptation of speculating. Such a temptation is always very attractive but must always be resisted. Speculation is beyond the scope of the job of an investment manager.
In the case of market aggregates or stock prices trading within a band. The theory hypothecates that such movements could indicate one of the two cases.
- Accumulation: Stocks flowing into the hands of the knowledgeable investor, which is a positive sign.
- Distribution: Stock flowing into weak hands, which is not a healthy sign for the markets or the stock.
Indication of a new trend is established when the line (market aggregate or stock price) breaks the floor or ceiling of the band. If the line has broken the floor then it signals a bearish trend. While a move above the ceiling denotes a bullish signal.
Price – Volume Relationship
The normal relationship between market aggregates or stock price and volumes is direct. Volumes should expand on rallies and contract on declines. Rallies on low volumes or vice – versa are not a healthy trend and one can expect a reversal.
Further, a bull signal is indicated if every primary peak surpasses the previous peak and every subsequent decline is above the previous secondary. A bear signal is when every decline surpasses the previous bottom and intervening advances are lower than the previous one.
Bull & Bear Markets – The theory also defines a bull and bear market and the stages involved.
- Bear Market: A long decline interrupted by important advances. It starts with participants abandoning expectations on which the stocks were first purchased. This is followed by companies failing to meet their earning targets, which leads to another round of sell off. Finally, there is complete gloom, as selling prevails irrespective of the inherent value. This could be due to depressed conditions or forced liquidations, which occur as a result of stop loss or for meeting margin calls. Feels like déjà vu.
- Bull Market: A long advance interrupted by important declines. The rally starts with market aggregates or stock prices reflecting the worst possible scenario and outlook on the future begins to revive. This followed by companies surpassing the expectations of investors leading to further optimism in equities. The last stage is when there is excessive optimism, which leads to speculation and market aggregates and stock prices reflect the best possible or impossible (bubbles) future scenario.
Technical analysis is not concerned with the state of the economy or the future earnings capacity of a company. Therefore, it is not concerned with the true value of a stock or a market aggregate and is not a tool for determining the same. However, technical analysis could facilitate in identifying short-term trends, which can assist the investor in timing his equity transaction.
Timing of investment decisions on the basis of Dow Jones Theory:
Ideally speaking the investment manage would like to purchase shares at a time when they have reached the lowest trough and sell them at a time when they reach the highest peak. However, in practice, this seldom happens. Even the most astute investment manager can never know when the highest peak or the lowest through have been reached. Therefore, he has to time his decision in such a manner that he buys the shares when they are on the rise and sells then when they are on the fall. It means that he should be able to identify exactly when the falling or the rising trend has begun.
This is technically known as identification of the turn in the share market prices. Identification of this turn is difficult in practice because of the fact that, even in a rising market, prices keep on falling as a part of the secondary movement. Similarly even in a falling market prices keep on rising temporarily. How to be certain that the rise in prices or fall in the same in due to a real turn in prices from a bullish to a bearish phase or vice versa or that it is due only to short run speculative trends?
Dow Jones Theory identifies the turn in the market prices by seeing whether the successive peaks and troughs are higher or lower than earlier.