Steve Nison is attributed to bringing CandleStick Charting into the Western world, and since his booklet titled ‘Understanding Japanese Candle Charts’ written for Merrill Lynch in 1990, candlestick charting has exploded into modern western society. Nison later expanded his original booklet in another book entitled ‘Japanese Candlestick Charts’. In this book he summaries the main advantages of using Candlestick Charts including:

• Being able to visually draw relationships between stock data
• Providing stronger insights into price behaviour and methods which are not directly apparent in other forms of stock charting
• The advantages that are provided in being able to see trading movements more easily in the short term

Signals are late

Perhaps the most common criticism of Dow Theories is that it is always late. Most analysts that criticise Dow’s Theory do so because it they believe that it does not accurately indicate top or bottom market moves. These criticisms are inaccurate since Dow’s Theory was never intended to indicate top or bottom market moves and consequent trading positions, but rather indicate the overall business cycle and the direction of the primary trend. It is often easy for many technical analysts in modern society to relate Dow’s Theory to that of day trading, and it is a foolish comparison since the two are measuring entirely different time spectrums.

Transport has changed

Technological changes have rapidly decreased the amount of freight that is delivered by railroad in modern society, and as a result the comparison between the two averages does no longer represent a complete economic picture of the market. While the Dow-Jones Railroad Average and the Dow-Jones Transport indexes exist, the future of their use remains in doubt with the increase of services as a proportion of output which will mean that these indexes will no longer be as useful.

Rhea notes in his book on page 15 that:

“A market which has been overbought becomes dull on rallies and develops activity on declines conversely, when a market is oversold, the tendency is to become dull on declines and active on rallies. Bull markets terminate in a period of excessive activity and begin with comparatively light transactions”

Hamilton further noted that volume was proportional to the direction of the primary trend. This implies that in bull trends, volume would substantially increase on upturns and substantially decrease on downturns while conversely for bear trends, volume would substantially increase on downturns and decrease on upturns. It was in this manner that Hamilton judged the strength of the market and ultimately the power of any forthcoming reversal.

Hamilton also noted that not only was volume proportional to the direction of the primary trend, but it also correlated strongly with reversal patterns. Typically, he found that just before a reversal occurred, strong volume accumulated and indicated clearly that undue market pressure was imminent.

In conclusion, volume should always only ever be used as an additional secondary tool to confirm your initial price based theory – it should never be entirely used to indicate a change in trend direction.

The Industrial Average represented the manufacturing and sale aspects of the economy, while the Railroad average represented the movement of goods from suppliers to the manufacturers, manufacturers to distribution warehouses and distribution warehouses to retail stores etc. The Railroad Average typically helped indicate the volume of goods being carried throughout the country with statistics such as tonnage, manufacturing output and overall inventory levels. The Industry Average helped to represent the volume of goods being produced throughout the economy.

Since it was definitively apparent that both averages were intertwined, an upturn or downturn in a particular Average would eventually effect the other average and it was in this manner that the law of two averages was derived for Dow’s Theory.

In Rhea’s 1932 book on page 14 he states:

“The movements of both the railroad and industrial stock averages should always be considered together. The movement of one price average must be confirmed by the other before reliable inferences may be drawn. Conclusions based upon the movement of one average, unconfirmed by the other, are certain to prove misleading…..Such movements have but little authority unless confirmed in directory by both averages, but the confirmation need not occur on the same day.”

Therefore the subsequent diagram illustrates how Dow used both averages to confirm a primary bull or bear trend. It can be seen that a bull market is declared when both averages have turned upwards from their previous trend – it is important to note that both averages must move upwards to properly confirm a bull trend.

It can be seen that a bear market is declared when both averages have turned downwards from their previous trend – it is important to note that both averages must move downwards to properly confirm a bear trend.

The most important aspect of this rule is that both averages must turn – it does not matter which average turns first, as long as the other average confirms it.

The diagram above shows two instances when Rhea’s definitions cannot exist simply because the market has crashed or risen so suddenly that there is no room for confirmation in peaks and troughs. Since Rhea studies on Dow Theory clearly states that peaks and troughs must be confirmed, the problem arises as to when the trend actually finishes.

There are two main ways to solve this problem and both can be used when using Dow Theory. The first suggests that the end of the trend, and possible start of a new trend, will occur when price moves above or below the last trough or peak. The only other method is to continue to follow Rhea’s logic and wait for a subsequent peak or trough as previously illustrated above.

The first method suggests that the end of a trend will appear like the following diagrams:

In Rheas 1932 book on page 14, he expresses his dissemination of both Dows and Hamilton’s work into one trend definition:

“Successive rallies penetrating preceding high points, with ensuing declines terminating above preceding low points, offer a bullish indication. Conversely, failure of rallies to penetrate previous high points, with ensuing declines carrying below former low points is bearish.”

It is interesting to note in this definition that Rhea refers to ‘peaks’ as ‘high points’ and ‘troughs’ as ‘low points’. In modern day technical analysis, the references to ‘high points’ and ‘low points’ has been predominately replaced by the use of ‘peaks’ and ‘troughs’, and from this point forward throughout this article the author shall refer to this later terminology.

Bull Trend

As Rhea previously concluded, a bull trend is defined as “Successive rallies penetrating preceding high points, with ensuing declines terminating above preceding low points, offer a bullish indication.” The subsequent, diagram illustrates a bull trend and the starting and ending configurations. It is critical to note from this diagram how and where a bull trend starts and finishes. The following provides a useful summary:

• A bull trend starts when price makes a high peak which is followed by another higher trough.
• A bull trend ends when price breaks below the previous trough after forming a lower peak

Each peak and trough must be verified in the trend to ensure that the bull trend is continuing such that each peak is validating the last trough and any new trough is validating the last peak. This point is so important because daily fluctuations can mislead many novice technical analysts into believing that the overall trend has changed. This is why it is critical that all trends are constantly verified to ensure that they are accurate. It is important to realise that is Rhea’s exact definition of a bull trend and is generally accepted as correct, although there are some circumstances where it is possible to question this logic.

Bear Trend

As Rhea previously concluded, a bear trend is defined as “Failure of rallies to penetrate previous high points, with ensuing declines carrying below former low points is bearish.” The subsequent, diagram illustrates a bear trend and the starting and ending configurations. It is critical to note from this diagram how and where a bear trend starts and finishes. The following provides a useful summary:

• A bear trend starts when price makes a lower peak which is followed by another lower trough.
• A bear trend ends when price breaks above the previous peak after forming a higher trough.

Each trough and peak must be verified in the trend to ensure that the ear trend is continuing such that each new trough is validating the last peak and any new peak is validating the last trough. This point is so important because daily fluctuations can mislead many novice technical analysts into believing that the overall trend has changed. This is why it is critical that all trends are constantly verified to ensure that they are accurate. It is important to realise that is Rhea’s exact definition of a bear trend and is generally accepted as correct, although there are some circumstances where it is possible to question this logic.

Three Main Primary Moves

As previously discussed, there are three main moves in respect to overall market movement and while these main three movements have been discussed in detail – there are also “movements within these main movements”. In order to envisage these movements, it is again best to refer to Rhea’s 1932 book on page 13. He comments:

“There are three phases of a bull period;

1. The first is represented by reviving confidence in the future of business;
2. The second is the response of stock prices to the known improvement in corporate earnings, and
3. The third is the period when speculation is rampant and inflation apparent – a period when stocks are advanced on hopes and expectations.

There are three principal phases of a bear market;

1. the first represents the abandonment of the hopes upon which stocks were purchased at inflated prices;
2. the second reflects selling due to decreased business and earnings, and
3. the third is caused by distressed selling of sound securities, regardless of their value”

The following diagram illustrates Rhea’s above comments:

It is interesting to note that most technical analysts today mainly study the short-term trading cycle in order to gain “quick profits” as opposed to longer term trending cycles. In all of Dow, Hamiltons and Rheas studies, the longer term trending cycle was typically the only cycle ever analysed, and thus the majority of Dow’s studies are reflective of this fact. In the authors opinion, the most efficient use of technical analysis is to review the entire market in a series of different timeframes (i.e. yearly, monthly, weekly) before trading on extremely short-term movements. This ensures that the overall long-and-short term market is captured, and can provide better insight into overall trading analysis.

Some other typical factors that can make analysis of the current trading cycle easier include:

• TV, Newspaper and Magazine coverage.
• Index analysis for buyer and selling pressures
• Market depth analysis
• Average market Dividend Yield
• Private equity levels & Initial Public Offerings
• Overall economic position

Dow, Hamilton and Rhea all agreed their were at least three market movements in relation to any market change. In Rhea’s 1932 book entitled, The Dow Theory: an explanation of its development and an attempt to define its usefulness as an aid in speculation!- on pages 12 and 13, he comments that:

“There are three movements of the averages, all of which may be in progress at one and the same time.

1. The first, and most important, is the primary trend: the broad upward or downward movement known as bull or bear markets, which may be of several years duration.
2. The second, and most deceptive movement, is the secondary reaction: an important decline in a primary bull market or a rally in a primary bear market. These reactions usually last from three weeks to as many months.
3. The third, and usually unimportant, movement is the daily fluctuation”

It is quite difficult to understand these three points without the aid of visual diagrams – none of which either Dow, Hamilton or Rhea ever provided. To make it easier for the reader, the subsequent diagrams attempt to illustrate the three points written above.

The Primary Movement

As written previously, Rhea commented on Dows ‘three market movements’ strategy suggesting that the most important movement is “the primary trend: the broad upward or downward movement known as bull or bear markets, which may be of several years duration.”

On page 13 of Rhea’s book he continues by commenting that:

“The primary movement is the broad basic trend generally known as a bull or bear market extending over periods which have varied from less than a year to several years. The correct determination of the direction of this movement is the most important factor in successful speculation. There is no known method of forecasting the extent or duration of a primary movement.

A primary bull market is a broad upward movement, interrupted by secondary reactions and averaging longer than two years. During this time, stock prices advance because of a demand created by both investment and speculative buying caused by improving business conditions and increased speculative activity.

A primary bear market is the long downward movement interrupted by important rallies. It is caused by various economic ills and does not terminate until stock prices have thoroughly discounted the worst that is apt to occur.

To illustrate how this primary movement would appear, the following diagram has been created:

The Secondary Movements

Rhea comments on Dows ‘three market movements’ strategy suggesting that the secondary movements, or fluctuations, are the “most deceptive movement” – simply because they are the most difficult to pick. As previously written, the “second, and most deceptive movement, is the secondary reaction: an important decline in a primary bull market or a rally in a primary bear market. These reactions usually last from three weeks to as many months”.

On page 14 of Rhea’s book he comments on Secondary Market movements:

“A secondary reaction is considered to be an important decline in a bull market or advance in a bear market, usually lasting from three weeks to as many months, during which intervals the price movement generally retraces from 33% to 66% of the primary price change since the termination of the last secondary reaction.

These reactions are frequently erroneously assumed to represent a change of primary trend, because obviously the first stage of a bull market must always coincide with a movement which might have proved to have been merely a secondary reaction in a bear market, the contra being after the peak has been attained in a bull market”

To illustrate how this secondary movements appear, the following diagram has been created:

Rhea also commented that secondary movements can also appear as ‘lines’ that show variation around the overall secondary movements. Rhea commented on page 14, that these as “price movements extending two to three weeks or longer, during which period the price variation of both averages move within a range of approximately give percent. Such a movement indicates either accumulation or distribution. Simultaneous advances above the limits of the ‘line’ indicate accumulation and predict higher prices; conversely, simultaneous declines below the ‘line’ imply distribution and lower prices are sure to follow.”

These ‘lines’ are illustrated in the following diagram:

Daily Fluctuations

Rhea comments in his book that daily fluctuations are not important for determining primary and secondary movements and can often mislead the technical analyst in their examination of the overall market. In true Dow Theory, modern day short term trading and daily fluctuations were not important and thus Dow never analysed these short terms movements to the levels that modern technical analyst’s do today.

Daily fluctuations are shown below:

Averages Discount Everything

The principal rule of Dow Theory is that averages must discount everything. The fact that the market disseminates all information (refer to Fundamental Analysis Tutorial)
and seeks to incorporate all the fundamental, political, macro and micro economic data as well as the risk component into the current market price at any one period, it suggests that these factors only influence the short-term trending patterns. The main primary trend will remain unaffected and will continue unchanged.

A good chart to illustrate this is the WBC History chart illustrated below. The start of the downtrend for Westpac began around December of the 1989 and continued through until around December of 1990. It is clear that the Westpac bank then recovered at the start, and towards the middle of 1991 but another downward reversal occurred around December of this same year, which reverted it back to its main primary downward pattern. Dow Theory suggests that the recovery which occurred during the start and middle of 1991 is a ‘secondary move’ and only ever occurs against the primary trend (Primary and Secondary Movements are discussed below).

Rhea noted in page 12 of his 1932 book that “The fluctuations of the daily closing prices of the Dow-Jones rail and industrial averages afford a composite index of all the hopes, disappointments and knowledge of everyone who knows anything of financial matters and for that reason the effects of coming events (excluding Acts of God) are always properly anticipated in their movement. The averages quickly appraise such calamities as fires and earthquakes”. Rhea derived this information from Hamilton’s notes where he suggested that the market would sometimes react negatively to good news, and positively to bad. Unknowingly, he touched on the fundamentals of Efficient Market Hypothesis and attempted to summarise it by suggesting that by the time any news reached the public, it had already been reflected in the price of the security. This theory has been touched on in our earlier Fundamental Analysis Tutorial and can be reviewed there.

Dows Theory is not Flawless

It is important to remember that the Dow Theory is “not an infallible system for beating the market. Its successful use as an aid in speculation requires serious study and the summing up of evidence must be impartial. The wish must never be allowed to father the though” (Rhea, Dow Theory, Pg 12). Hamilton had also previously confirmed this by writing “The Theory is not infallible. If someone did find such a system, then he or she will own the world in relatively short order and speculation as we know it will not exist.” Rather, it is a system that should be analysed for its fundamental ideas, and to understand Technical Analysis in its entirety. In current day trading markets there a number of flaws in the Dow Theory that deserve comment, as they are often overlooked by many Dow Theorists. In saying this, it is important to understand how the Dow Theory was constructed in order to understand the problems.

The Dow Theory was originally constructed on only one market average, and was later split between two different markets – namely, the Industrial and Railroad markets. Dow used these two markets because he felt that they encompassed the majority of trading activity at the time, and when averaged, accurately represented total market movement. Industrial stocks were calculated as an average and depicted all manufacturing that occurred as well as the sale of any goods. Equivalently, the Railroad average accurately illustrated the movement of goods throughout the market itself. Dow’s philosophy behind using these two averages was that Railroad average was highly correlated to the volume of goods being carried. This meant that volume of goods being carried was also very reliant on the amount of goods being produced, or rather, the amount being manufactured. Consequently, Dow identified a bull trend as a period where the goods were ordered and moved by railroad, which led to inventory being lower and caused manufacturing to increase to account for this new inventory deficit. As a result, this led to improvements in both the Railroad and Manufacturing averages. Dow also noticed that the Manufacturing average was always lagging behind the Railroad average, and concluded that it was due to the fact that orders and delivery by Railroad companies would occur first, which would then lower inventory holdings and as a result, generate more manufacturing to reach supply and demand equilibrium. Conversely, he also noted that at the start of a bear cycle orders typically fell away, which in turn, caused inventory to build up and therefore lead to railroad companies delivering less goods. This lead to an oversupply of goods in the market which caused manufacturing production to decrease, and led to decreases in the both Industrial and Manufacturing averages.

It is important to realise that although Dow identified bull and bear market movements by these instances, it does not actually imply that this is how the two averages always moved. Hamilton summarised this by suggesting that “Both the Industrials and Rails (the modern day Transports) must confirm each other in order for the signal to have authority”, implying that the two averages must only “confirm” – not follow Dows exact definition. While this statement has led to a more exact Technical Analysis definition of a bull and bear market today, its application when using only Dow Theory in the modern market has found deep criticism. This has been primarily due to the fact that the development of air, sea and road travel has lead to a reduction in use of railroad transport as the primary source of goods movement in the market. While proponents for the Dow Theory claim this has been handled by the introduction of the Dow Jones Transport average, economic critics still claim that the Industrial average can no longer be used to confirm the Transport average because it now encompasses the production of both goods and services – not just goods as it had previously.

While it is well accepted that Dow Theory is more accurate during long term trending markets as opposed to ranging markets, it was sometimes also used accurately by Dow, Hamilton and Rhea in daily price forecasting. Critics have argued that the Dow Theory is unable to accurately measure intra-day price changes because it relies on closing prices at an end of day level. The Dow Jones averages original used closing day prices only because it was too difficult to judge intraday pricing levels.

Introduction

Charles Dow is accredited as one of Wall Street’s most important figures for a number of very different reasons. Firstly, he was solely responsible for the formation of The Wall Street Journal (WSJ) as well as the first market index – the widely renowned Dow Jones Industrial Average. Furthermore, he is considered to be the Father of Technical Analysis and his theories form the basis of all Technical Analysis today. Ironically, Dow never received full credit for his achievements, and passed away at the age of 51 at his home in Brooklyn during 1902. It was not until many years later that he was recognized as completely revolutionizing the way that the stock market is discussed and analysed – with investors around the world realising the importance of his work.

“A person watching the tide coming in and who wishes to know the spot which marks the high tide, sets a stick in the sand at the points reached by the incoming waves until the stick reaches a position to where the waves do not come up to it, and finally recede enough to show that the tide has turned.

This method holds good in watching and determining the flood tide of the stock market. The average of (stock prices) is the peg, which marks the height of the waves. The price-waves, like those of the sea, do not recede all at once from the top. The force which moves them checks the inflow gradually, and time elapses before it can be told with certainty whether high tide has been seen or not”. – Charles Dow, Janurary 31, 1901, The Wall Street Journal

The Dow Theory itself has been around for more than 100 years and is still used in the market trading today. However, what is less known about Dow Theory, was that it was actually the work of Charles Dow, William Hamilton, S.A Nelson and Robert Rhea whom produced the majority of the underlying fundamental theorems – not just Dow himself.

William Hamilton writings captured what Dow could not write down on paper, and in doing so, he was able to interpret and expand upon on many of Dow’s original ideas. Hamilton considered Dow to be fair too cautious in his market forecasts and even went so far as to say in his, The Stock Market Barometer book published in 1922, that Dow “would write a strong, readable and convincing editorial, on a public question affecting finance and business, and in the last paragraph would add safeguards and saving clauses which not only took the sting out of it, but took the “wallop” out of it. In the language of the prize ring, he pulled his punches.” In saying this, it was widely accepted that Hamilton had the utmost respect for Dow and sought to promote and expand upon his ideas to the point where they would be widely accepted. Unfortunately for Hamilton, he was never able achieve this feat partly due to his own failings. Hamilton only ever applied Dow’s Theories to the overall market and never attempted to use them on individual stocks – a weakness that even Rhea could not capitalise on. Hamilton considered himself as a journalist and market commentator, not a trader, which explains why he never bothered to expand Dow’s work deeper into the market. While this may be considered his greatest down fall, it is important to remember that is was only through Hamilton’s persistence of Dow’s theory that Technical Analysis has been so successful today. Interestingly, even up to his death in 1929, Hamilton never claimed credit for any of Dow’s literature which he had expanded upon. While Hamilton’s ideas clearly evolved over time while writing for the Wall Street Journal, he insisted that he was merely commenting upon original thought paths that Dow had failed to write down. Whether or not Hamilton truly did expand on Dow’s theories is a question that is still debated today – however, it is now well accepted that his expansion of Dow’s work, and unwavering commitment to promote its principles, gives him the right to receive credit for his work.

“On the late Charles H. Dow’s well-known method of reading the stock market movement from the Dow Jones Averages, the twenty railroad stocks on Wednesday October 23 confirmed a bearish indication given by the industrials two days before. Together the averages gave the signal for a bear market in stocks after a major bull market with the unprecedented duration of almost six years…” William Hamilton, October 25th, 1929, The Wall Street Journal

Another very important figure in the expansion of Dow’s work was S.A Nelson who wrote The ABC of Stock Speculation which was published in 1903. Nelson was a close friend of Dow’s who attempted, unsuccessfully, on numerous occasions to get him to write down his ideas down in a book. This meant that the only record of Dows ideas were in the articles that he published from 1901 to 1902 in the Wall Street Journal Editorials before his death. Interestingly, Nelson republished the majority of these articles in his The ABC of Stock Speculation book and sought to use these as a basis for expansion on Dow’s thought processes. Nelson was able to successfully expand on some of Dow’s ideas in his book and was the first journalist to refer to Dow’s studies as “Dow’s Theory”.

The final, and perhaps most important person, in tying together the fundamental ideas of the above traders was Robert Rhea. Rhea was undoubtedly a student at heart, and always considered himself so. He constantly sought guidance from his teachers in all aspects, which is illustrated in the deep references he makes to all those who passed before him in his book The Dow Theory, and his newsletter Dow Theory Comment. While accredited as the man who took the Dow Theory to the “next level”, he too missed some fundamental elements of the Dow’s research that could have been expanded upon much earlier. Rhea based the majority of his research on that of his predecessors, and as result, missed everything that Hamilton and Nelson did. He saw the most useful application of the Dow Theory as the determination of trending cycles in overall stock movement, rather than that of individual stocks. Interestingly, although Rhea studied Dow’s editorials extensively, he seemed to miss Dow’s extensive commentary on individual stocks and his analysis of their trading and swing patterns. It is thought that Technical Analysis may have developed a lot faster if Rhea’s work had encompassed individual stock analysis. In saying this, Rhea did managed to expand on Hamilton’s findings that overall Market movement was dealt with through the analysis of ‘swing patterns’ over time. He confirmed Dow’s findings that the stock market anticipated changes in business conditions, and as a result, agreed with Dow’s findings that analysing the market in this fashion can lead to accurate predictions of changes in the real economy. Consequently, Rhea’s analysis and definition of Dow’s work deserves recognition, and his contribution to the extension of Dow’s Theory must be acknowledged.

The following is the Preface from Rhea’s book – The Dow Theory:

“I have no qualifications to justify my writing a book on the Dow Theory except a firm conviction that it is the only reasonably sure method of forecasting stock market movements.

When a man is confined to bed for a great number of years as I have been, he has an opportunity seldom afforded others for study and private research, and unless he avails himself of some such privilege and considers it as offsetting the pleasures enjoyed by more fortunate men, he is apt to lose interest in life.

For more than ten years my business affairs have been conducted from my bed and my only recreation has been the study of business economics- particularly the trends of business and of the stock market; and either the Dow Theory or just plain luck caused me to buy a few stocks at the proper time in 1921 and prevented my owning any during the final stages of the 1929 uprush. Moreover, either Dow Theory or luck caused me to carry a short account of small proportions during the two years after the crash.

Thus, my study has paid dividends, and if I can explain the theory as I try to practice it, others may be helped. I hope so anyhow.” – Robert Rhea, The Dow Theory, 1932