Identify the Primary Market Trend using The Dow Theory

The correct determination of the direction of the primary trend is the most important factor in successful speculation (trading and investing). The primary trend (also referred to as movement) is the broad basic trend generally known as a bull or bear market lasting a period of time from less than a year to several years. The primary trend is the most important of the three movements discussed within The Dow Theory.

The Dow Theory also includes movements such as the secondary reaction and the daily fluctuations. I am not interested in daily action because these short term movements are typically unimportant.

Edwards and Magee said:

“The Dow Theory is the granddaddy of all technical market studies” and “It is built upon and concerned with nothing but the action of the stock market itself (as expressed in certain “averages”), deriving nothing from the business statistics on which the fundamentalists depend”

The purpose of this post is to highlight the Principle of Confirmation which states that The Two Averages Must Confirm. The authors note that this principle has often been questioned and is the most difficult to rationalize of all the principles yet it has stood the test of time.

They go on to say:

“the fact that it has “worked” is not disputed by any who have carefully examined the records. Those who have disregarded it in practice have, more often than not, had occasion to regret their apostasy”.

Please repeat the following rule several times and learn it, understand it and trade by it:

“What it means is that NO valid signal of a change in trend can be produced by the action of one average alone”.

Here is a chart from the 4th edition of their book Technical Analysis of Stock Trends, published in 1957

Now take a look at today’s Dow Jones and Transports. Do you see any similarities?

Of course you do, the Transports have not confirmed the change in trend along with the DOW. In fact, the $DJIA is now back below the resistance line after this week’s negative action.

Many traders on StockTwits, Twitter, blogs and TV (if you still watch financial television) are miffed about the action of the market over the past several weeks, particularly the past week. Well, the trend hasn’t confirmed so the risk is still high that the so-called “leaders” are setting up for failure or head-fakes.

I’ve started to sound like a broken record with my Dow Theory tweets but if it is fact, it is fact. As traders, we must be patient and wait for the confirmation before loading up on new shares. A trend change may still occur but we must cast a shadow of doubt until both averages confirm.

If you don’t want to listen to me, a lowly stock blogger, at least listen to what Robert Rhea said in 1932:

“The movement 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 almost certain to prove misleading.”

Please note that “railroads” have been replaced with “transports” in today’s world.

Trading can essentially be broken down to managing risk and as Victor Sperandeo stated, “market forecasting is a matter of probabilities; the risk of being wrong is always present”.

So why tilt the risk against you if history shows us that both averages must confirm for a sustainable change of trend to take place. It’s a wacky world out there but the rules haven’t changed so wait for the confirmation before jumping in with both feet.

Market observation from Thursday, November 17, 2011: The NASDAQ has now flashed four distribution days since the start of the month. This is a red flag and a signal to lock in profits and sell losing positions before they grow in size.

Continue to follow me on twitter for daily tweets, charts and links to great articles.

Comments

  1. Brad Miller says:

    I always get a kick out of reading how history repeats itself and this empirical historical data validates one’s view point today. Here is my viewpoint. Whatever happened in the past doesn’t mean squat in this new paradigm . Look at the 50 year S& P chart, look at when computers started trading.
    Now ask yourself what is the stock market … a vehicle for companies to raise cash to support growth and innovation. I don’t think so my naive pal . Its a mechanism to extract as much money from the economy as it can with HFT, CDO’s and all means of smoke and mirrors so excuse me when I laugh in the face of a anachronism such as yourself . I’m an early adopter and I get it…all things flawed rule and your charting was not flawed in previous paradigms therefore cannot rule now.. Nice try though.

  2. Great post

  3. Brad, it’s a game of risk and probabilities, that’s all. Your comment shows that you don’t understand the post or don’t trade often. The post doesn’t try to take a 1920’s theory and fit it to today. It uses the theory to allow a trader to access risk and trade based upon that information.

  4. Great post Chris, going to link to it for my Cleveland linkfest tomorrow

  5. Greg, thanks – hope you are keeping warm!

  6. Veijo Ryhänen says:

    Very BIG thank You, Chris ! I have followed writings below your “Recent post” title in this website and I have “trading” accordingly – it works ! Amazing! :-)

    When I said “trading”, I mean that I have not done anything _against_ “high probability” (actually I have followed = believed partly).

    Please continue to write new “Recent post” when you find something new “high propabilities”.

  7. Leading stocks have blasted off your recent red flag warning, averages continuing their pinball action but leading stocks crowding nearer and nearer to the top of their 13 year consolidation range hinting that the end is very near for the typical 15-20 year consolidation range. The market should breakout within a few years returning to it’s primary trend and subsequently growth stocks should swing stongly into favor over value as we are seeing in some of the new leaders. The probabilities are shifting that the primary trend is changing and that’s something each investor needs to remember with each “shakeout” or red flag warning.

  8. Things have changed since the onset of computerized trading and retail trading.
    See my comparison of the market seasonality – sell in may and go away.

    http://michaelthamm.files.wordpress.com/2011/12/sellmay.jpg

    But I also believe that the psychology of the market, and I think that is what the two charts are describing is as valid today as in 1957.

Trackbacks

  1. […] Back to basics: what Dow Theory says now.  (Chris Perruna) […]

  2. […] Back to basics: what Dow Theory says now.  (Chris Perruna) […]

  3. […] Identify the Primary Market Trend Using Dow Theory (ChrisPerruna) […]

  4. […] Identify the Primary Market Trend Using Dow Theory (ChrisPerruna) […]

  5. […] This is from the blog of Chris Perruna, the full article is here […]

  6. […] Back to basics: what Dow Theory says now.  (Chris Perruna) […]

Speak Your Mind

*