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Section 7, Lecture 9
Modern Technical Analysis and Dow Theory
The practice of technical analysis in some forms were present for many centuries
but Charles Dow (18511902) was the first to reintroduce and comment on it in
recent times.
Charles Dow developed Dow Theory while working with the Wall Street Journal back
in 1897. Robert Rhea refined by further refined the theory in 1932, and later S.A.
Nelson and William Hamilton improved the theory into what it is today. The ideas
put forward by these men have become foundation of todays Technical
Analysis. There are six basic tenets of Dow Theory, and they are as follows
1. The Averages Discount Everything Dow hypothesized that prices discounted
everything, including expectations, to the point that they are predictive of events.
He put forward this concept where he explained as new information arrives, market
participants quickly disseminate the information and the price adjusts accordingly,
similarly, the market averages discount and reflect everything known by all stock
market participants.
2. The Market Is Comprised of Three Movements Dow identified three types of
price change in the market. These changes are simultaneously present in the
market. These changes are known as Primary, secondary and minor movements
Minor movements These are short-term movements lasting from one day to
three weeks. Secondary trends are typically comprised of some Minor trends.
3. Primary Trends Have Three Phases In this theorem, Dow postulated that
there are three Stages of Primary Bull Markets and Primary Bear Markets.
In the bull market, the first phase is made up of aggressive buying by informed
investors in anticipation of economic recovery and long-term growth. The first stage
and the railroads index) move in tandem then only one could confirm that a major
trend is in place.
5. The Volume Confirms the Trend The Dow Theory primarily focuses on pricing
trends, however, to confirm uncertain situations volume is only used. The theory
states that the volume should increase along with the price in the direction of the
major trend. If the primary trend is down, then volume should increase during falling
market. If the primary trend is up then, volume should increase during rising
market.
6. A Trend Remains Intact Until It Gives a Definite Reversal SignalThis
theorem relates a physical law to market movement; it is an adaptation of Newtons
First Law of motion. This Theorem posited that an object in motion (in this case a
trend) tends to continue in motion until some external forces cause it to change
direction.
In other words, an uptrend is defined by a series of higher highs and higher-lows.
For an up-trend to reverse, prices must have at least one lower high and one lower
low then the reverse is true for a downtrend.