Technical analysis I

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4. Dow Theory

In 1887 Charles Dow (as in 'The Dow Jones') developed two stock market 'averages':

• The Industrial Average, made up of 12 blue chip stocks
• The Rail Average, made up of 20 railroad companies

In 1900 he wrote a series of articles noting that the direction of prices in each average appeared to be based on a set of rules. Collectively, these became known as The Dow Theory and the key precepts are summarised below.

Dow Theory

1. A share price reflects everything that is known about a stock

   This means that all the positives and all the negatives about a company are assumed to be known by the market and built into the share price. Implicitly, no stocks are undervalued, because the market has 'perfect' knowledge.

2. At any given time, there are 3 trends unfolding in the stock market:
   • The primary trend lasting for more than one year
   • The secondary trend which is a corrective reaction to the primary trend and usually lasts from one to three months
   • The tertiary or minor trend which is a short term movement lasting from one day to three weeks.

3. Primary trends have three phases
   • Aggressive buying by well informed investors ahead of economic recovery while most investors are still bearish about the market
   • General buying by the majority of investors as company earnings pick up and and economic conditions improve
   • Headlong rush into stocks by everybody, as companies report record earnings. Meanwhile, the well informed investors are starting to sell even though prices may be rising.

4. Volume Confirms the Trend

   Rallies in the market are accompanied by increasing volume, and falls with decreasing volume.

5. A Trend Continues Until a Reversal Signal

   If a primary trend is confirmed by the movement of both averages it will continue until there is a definite reversal signal. So once a primary trend has started the chances are it will continue, but once it has been around for a while the chances of continuation are less.

If you are new to technical analysis, don't feel that you have to fully understand the five precepts above. The point at this stage is to get a feel for the way technical analysts think about the stock market, with prices moving in cycles and being determined by a set of rules.

1. What is technical analysis? 2. Technical analysis compared to fundamental analysis 3. What technical analysis is not 4. Dow Theory 5. Price data 6. Volume data 7. Line charts 8. Bar charts 9. Volume charts 10. Point and figure charts 11. Other types of chart 12. Trends - the basics 13. Simple trend lines 14. Making money from trend lines 15. Trend channels 16. Support and Resistance 17. Breakouts 18. Is technical analysis for you? 19. Software for technical analysis 20. Conclusion

• An Introduction to Technical Analysis - Reuters Financial Training Series
• Technical Analysis Plain and Simple
• Technical Analysis of the Financial Markets
• Martin Pring's Introduction to Technical Analysis