Finally, folks, we get to it – the Dow Theory …
The first thing you need to understand is I am not big on theories that purport to predict broad-market movement. Like individual markets, the broad-market is subject to the often irrational influence of its participants. Thus, predicting broad-market movement is something much less than scientific or mathematical. It is more aligned with astrology. One takes astronomical data (technical data) and predicts a set of circumstances (market movement). Sometimes the conclusions are correct, and sometimes they are not. Proof of this is the daily disagreement between renowned market analysts. One says the technical data will move the market up and another says the same data indicates market movement down. To be clear, though, I believe there is real value in technical analysis. I have based many a trade on it, and will continue to do so, but I don’t use it as a predictive tool. I use it as an analytical tool to determine entry/exit points and as a tool to confirm potential market movement, which brings us back to Dow Theory.
Dow Theory has been around since 1884, some 126 years. Many traders swear by it as a trading tool, and some argue it is the “Holy Grail” of trading. Historically, if you invested from day one using the theory, you would be in positive territory. Of course, one could argue that about any valid market-investment theory that broadly invested in the stock market, as the stock market itself has a positive overall return since its inception. This, though, is not the important point about the Dow Theory. What I want to discuss is the value I see in it as another tool for traders.
The underlying premise of the theory is simple and rich with common sense. The two components of the theory are the two indices: the Dow Jones Industrial Average (DIJA) and the Dow Jones Transportation Average (DJTA). The key to the theory is the relationship between the two. The DIJA represents the 30 largest companies in the market and the DJTA represents the largest transportation companies in the market. Here is the common sense aspect – the correlation between the two forecasts potential market movement.
If the 30 largest companies are producing and selling product that product needs to be shipped. If the largest transportation companies are shipping product, it means that 30 largest companies are producing product. So beautifully simple and it makes sense to a degree. I say to a degree because back at the turn of the century, and for most of the 20th century, we were a manufacturing nation. Products, primarily, not services, drove the economic growth. This is no longer the case. In today’s economy, both products and services drive the economy. As well, many of the products and services consumed are digital. They don’t actually physically exist. They are shipped through the Ethernet, sent over telephone lines, beamed from satellites, and delivered to the consumer via the Internet.
Given the above, why would anyone give value to the Dow Theory? The answer does not reside in the simple premise of the theory; the answer lies with the three basic tenets of the theory. These tenets are universal and timeless in the world of markets, and even though you can agree or disagree with any or all, they are, nevertheless always technically applicable. The three tenets are:
- the averages discount everything;
- the averages consist of three price movements, and;
- both averages must confirm.
Enough for today, but tune in tomorrow, and I will explain how this theory can help all of us understand the big picture on both the markets and the economy, and after that I will explain how it just might help you increase the all-important edge you need to be a successful trader/investor.
Trade in the day; invest in your life …
