One of the oldest stock market prediction systems, the Dow theory, has been around for over 100 years. Based on the principle that one trend should confirm another, the Dow theory tracks the interactions of the Dow Jones Industrial Average and the Dow Jones Transportation Average. The theory has been modified over the years as economic and market conditions have changed, but it remains a valid predictor of market conditions.
The Dow theory is based on reasonable assumptions. Foreshadowing the efficient market theory, the Dow Theory assumes that all current knowledge and information about a company and the economic climate is incorporated in share prices. There is no insider information, nor is it possible to manipulate market trends. The theory is not designed to predict individual stock movements, but rather to predict broad market trends because individual stocks can be manipulated. The DJIA and DJTA must move together to establish a trend and are confirmed by trading volume. Trends continue until reversals signal an end.
Theory in a Nutshell
The core principle of the Dow theory is intuitively obvious. The DJIA relates to the strength of the nation's productivity, while the DJTA is indicative of how much production is being moved around the country. In a strong economy the two averages should trend together -- companies producing a lot and transporters moving it to consumers. In a down economy the two averages trend downward together as less is produced and shipped. If the two indexes move in different directions they signal a reversal of trends.
Market trends -- either bull or bear -- follow predictable patterns. Each trend has three components. The primary trend is either a bull or bear market itself. Within the primary trend are secondary movements -- corrections in a bull market and reaction rallies in a bear market. The market movements are the shortest fluctuations in the market. A primary trend lasts for at least a year -- perhaps three years or longer. Secondary movements are measured in months -- usually no more than three -- while minor movements last for only a few days or weeks. Trading volume is heaviest in the primary trends.
Primary Trend Stages
Each of the primary trends is marked by three stages. In a bull market the first stage is accumulation. The market players exhibit uncertainty, and while small investors are trying to figure out market direction, sophisticated investors are snapping up stocks at bargain prices. The second phase is the longest. The stock market moves up until it peaks in the excess phase. Corporate profits are high and speculation has driven up prices. The bull gives way to the bear when smart investors begin to close their positions even as small investors are still buying. Then the market makes its big move downward until despair takes over. Smart investors have liquidated their positions and small investors are wiped out.
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