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Dow Theory Unplugged: Charles Dow's Original Editorials and Their Relevance Today is a collection of 220
original Wall Street Journal editorials penned by Charles Dow that form
the basis of modern Dow theory. The following excerpt is the modern-day
introduction to one of the sections of the book.
The
Market Has Three Phases
By Paul Shread, CMT
Dow believed that major bull and bear markets each
have three phases: the early stages of a new trend, when smart money
begins to accumulate positions; the middle phase, when the reasons for
the new trend become apparent; and the final stage, when public
participation is high and investors discount not only present
conditions, but future possibilities too.
Bull markets begin when economic conditions are
still poor and the news discouraging, as the smart money begins to
accumulate positions. In the second phase, the improvement in business
conditions becomes apparent and corporate earnings rebound, drawing in
more investors and sending prices higher. In the third phase, the public
becomes heavily involved and the news is all good. Speculative excess
becomes evident as stocks are driven to heights that not only discount
current conditions, but future growth as well. It is at this point that
the smartest investors begin to take money off the table.
“The market will ultimately turn when general
business is still good, but not far from a turn,” [William Peters]
Hamilton wrote in April 1922. [He was Dow’s successor at the Wall Street
Journal.]
This early distribution marks the beginning of bear
markets, as big players begin to sense that economic conditions may have
peaked. The public begins to get frustrated as rallies fail. In the
second phase, selling picks up and the decline accelerates as business
activity and earnings falter. This panic phase is where the greatest
declines are seen. The third and final phase of bear markets occurs when
the news is all bad and investors are forced to sell at any price to
raise cash. When all the bad news is priced in, farsighted investors
begin to accumulate positions for the eventual recovery.
The market, Hamilton wrote in November 1922,
“recedes to a safer level until it is entirely clear as to the nature of
the unfavorable symptom which it cannot yet diagnose with certainty.
Indeed, it may almost be said that a bear argument understood is a bear
argument discounted.”
The market can reverse at any time, of course, but
the clearer the three phases have been, the more significant the
reaction is likely to be.
The years 1929, 1968, 1987, and 1999 all had clear
speculative excess, and all were followed by significant bear markets.
The end of World War II brought with it fear that the U.S. would fall
back into a depression, thus setting the stage for a long uninterrupted
bull market after the panic of 1946. The year 1982 was marked by the end
of a sixteen-year bear market and cover stories about “The Death of
Equities,” setting the stage for the greatest bull market of them all.
GAUGING SENTIMENT
Valuation and sentiment thus play an important role
in determining which phase the market is in.
On April 9, 1901—a little more than a month before
the onset of a market panic—Dow wrote, “There has been a gigantic bull
speculation, showing daily transactions of over 1,200,000 shares. There
has been a recent public demand for stocks affording large operators
opportunity to sell. Some of the houses which were among the largest
buyers some time ago have been sellers in the last week on an equally
large scale. ... The supply of money available for speculative purposes
has gradually diminished, while the offerings of securities have
increased.
“This is not proof that the bull market is near its
end, but developments like these will surely occur when the end of the
bull market comes. Therefore, such conditions should promote
watchfulness.”
Sometimes speculative excess is readily apparent,
as it was in 1929 and 1999. In fact, Hamilton’s and [Robert] Rhea’s
writings about 1929 could just as easily have applied to 1999, when
Internet companies with no earnings were bid up to stratospheric
valuations amid talk of a “new era.” [Rhea was a contemporary of Dow and
a prominent Dow theorist.]
“The student should ask himself if stocks are not
selling well above the line of values, if people are not buying upon
hope which may be at least deferred long enough to make both the heart
and the pocketbook sick,” Hamilton wrote in April 1929.
“Worthless equities were being skyrocketed without
regard for intrinsic worth or earning power,” wrote Rhea. “... Veteran
traders look back at those months and wonder how they could have become
so inoculated with the ‘new era’ views as to have been caught in the
inevitable crash.”
The 2007 top, on the other hand, did not witness
much in the way of stock market speculation. Leading issues like Google,
Apple, and Research In Motion were bid up to extraordinary heights, but
those gains were also backed by strong earnings and sales growth. The
speculation was much greater in the housing market—particularly in risky
subprime mortgages and myriad ways they were repackaged and leveraged.
Perhaps the historic collapse of Wall Street investment banks and other
pillars of the U.S. financial system will be the first step toward
greater oversight of derivatives, hedge funds, and other speculative
areas the U.S. government has until now treated with a hands-off
approach.
Dow’s notion of market trends and phases also
became the basis for Elliott Wave theory, founded by R.N. Elliott in the
1930s. Under Elliott Wave theory, primary trends unfold in three phases
and five waves. Wave one, the beginning of a new trend, shows a great
deal of uncertainty and can be followed by a very sharp wave two
reaction where it is not yet clear that the major trend has changed.
Wave three—the strongest wave—then follows as it becomes clear that
underlying conditions have changed. Wave four is typically a sideways
correction, since the fear that predominated in the first two waves has
now ebbed. Wave five, the final wave in the primary trend, becomes
tenuous and selective as the smart money begins to position for a
reversal. Paul
Shread, a Chartered Market Technician (CMT), is an editor and analyst
for
internet.com, where he published an article on the
November 2007 Dow Theory Sell Signal and the
July 2009 Buy Signal. He has been a guest on the
Gabe Wisdom show on Business Talk Radio Network.
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