La tipología de las tumbas

The theory had its beginnings in editorials written from 1900 to 1902 by Charles H. Dow in the Wall Street Journal. Dow’s good friend S. A. Nelson tried to persuade him to put these ideas into a book. Dow resisted, and so Nelson wrote it himself. He published The ABC of Stock Speculation in 1903 following Dow’s death the previous year. The book included 15 of Dow’s seminal Wall Street Journal editorials on the subject of speculation in the market. It was in this book too that Nelson first coined the term

“Dow Theory.” The theory was subsequently expanded upon and refined by William Peter Hamilton, Dow’s understudy and the editor of the Wall Street Journal,in editorials titled “The Price Movement,” as well as in his book, The Stock Market Barometer, published in 1922. However, it was left to Robert Rhea to organize and summarize the theory more fully. Rhea was confined to bed for many years with tuberculosis and a damaged lung.

He used this time of enforced physical inactivity for study of business and the markets and to hone his understanding of the trends that, according to Dow and Hamilton, characterize the market. In his 1932 book, The Dow Theory,Rhea wove together the various strands of the theory, including 252 editorials by both Dow and Hamilton, setting them out in a structured way designed to be of practical use to the individual investor. As mentioned above, it was in Rhea’s 1934 work The Story of the Averages, that he used ocean metaphors to describe the three basic trends of Dow Theory. “I like to think of Dow’s three movements as being the tide, the wave, and the ripple, all acting, reacting, and interacting at the same time. Consider a rising tide: as part of the tide we may have an oncoming or a receding wave, but on the wave may be an incoming ripple, or perhaps a ripple acting against the tide.”²

According to both Hamilton and Rhea, there are certain key assump-tions that need to be accepted in order to understand and use Dow The-ory. The theory asserts that the primary trend of the overall market can-not be altered through market manipulation, even though individual stocks are subject to short-term and even medium-term manipulation. A focus on market manipulation today seems a little antiquated and a reflection of the times in which the Dow Theory was formulated, the late 19th cen-tury, when market manipulation indeed was rife. Today the market is much broader and deeper compared to what it was over 100 years ago or during the Depression pre-World War II time of Rhea’s writing, so manipulation of the entire stock market today would appear to be a much more ambitious and probably impossible endeavor. It is true that individual stocks can be manipulated, particularly smaller stocks, through accounting fraud, the de-liberate spreading of rumors, and big investors deciding to act in concert

Tides, Waves. . . and Ripples 39

while taking short positions. Also individual market manipulations such as the Hunt brothers’ attempt to corner the silver market in 1980 or the ma-nipulation of California’s Energy market in 2000 and 2001 by Enron and other energy trading companies are perfectly possible to envisage in mod-ern times. Manipulation of the overall U.S. stock market today, however, appears to be a concept lacking any real feasibility.

Another major assumption that followers of the theory are advised to accept is that every known fact is already discounted in the market.

In other words, stock prices reflect all available information, including all hopes, disappointments, fears, and other emotions of market participants, as well as all extant knowledge of economic factors. These include inter-est rate trends and earnings expectations for all companies quoted on the market. Political events such as presidential elections and domestic and external strife are also included. Only the unknown and unknowable, such as catastrophic “Acts of God” are not reflected in current prices. (See our take on this in Chapter 2.)

A third assumption that adherents to Dow Theory accept is that the Theory itself is not infallible. It can guide the investor in his understanding of what the trends mean, but is not immutable science.

The Dow Theory concentrates on identifying the primary trend be-cause followers of the theory believe that the correct recognition of that trend is the best means to making money in the market. As Rhea put it, “The correct determination of the direction of this movement (primary trend) is the most important factor in successful speculation.”³ These primary trends can last many years, and correspond to what is usually termed either a bull or bear market. In Dow’s day, these terms had not yet come into use and the primary trends were still generally called “booms” and “panics.” In Rhea’s parlance, the primary trend is like a “tide,” and the point at which the primary trend changes from bull to bear or vice versa is described aptly as a turning of the tide.⁴

Secondary “reactions” move against the prevailing primary trend for a time, with a life span of perhaps a few weeks to several months. These are called market corrections when they are on the downside and go against a prevailing bull market—or market rallies when on the upside against a prevailing bear market. Robert Rhea dubbed these moves waves. For Dow Theorists, secondary reaction moves are considered to be the means by which the market ensures that excessive speculation and possible over-heating or cooling of markets is kept in check. Of course, there is always the possibility that corrections and rallies are mistakenly identified as a change in the primary trend; but it is one of the aims of Dow Theory to identify these trends correctly in order to ensure that speculative market activity takes advantage of them and is not stymied by them. This is not very easy to do, however, as even the staunchest followers of the Dow

Theory would admit. Rhea considers the secondary reaction as the “most deceptive” of trends.⁵

Finally, there are daily fluctuations that can move with or against the primary or secondary trend. Their defining characteristic is that they are short-lived, lasting from a few hours to a few days, and then reverse them-selves. In Rhea’s lexicon, these fluctuations are the ripples. According to Dow Theory, while short-term market movements can be useful when grouped together to aid analysis of the bigger picture of secondary or even primary moves, these ripples are insignificant when identified or analyzed on their own. Followers of Dow Theory believe that these short-term fluc-tuations have no real importance or value in pointing to primary or even secondary trends and are no more than background noise. Rhea was cer-tainly very dismissive of any attempt to make money by exploiting these short-term fluctuations:

It will be seen that these minor movements rally and decline, back and fill, and generally perform in a manner most perplexing to the man who is trying to watch each day’s fluctuations in hopes of scalp-ing a few dimes out of a few shares of stock while payscalp-ing commis-sions, taxes and brokerage.⁶

In retrospect, Rhea can be viewed as the first observer of markets to have provided a strong critique of day trading as a money-making practice.

Bulls and Bears

Dow Theory sets out three distinct stages to a primary trend bull market as follows.

Stage 1: Accumulation. This is the first budding stage of a bull market or

“boom” in the vernacular of Dow’s day, when there is still great pes-simism regarding the future. As expectations rise that things will im-prove, stock prices begin to rise also. There is increasing recognition that a bull market is underway. Nevertheless, this growing optimism is tempered by lingering fears and doubts that what is happening is sim-ply a rally within a continuing bear market. This is the stage when the smartest and most perceptive of value investors see their opportunity to come into the market at cheap levels.

Stage 2: General advance. This stage takes hold as improving business conditions and a boost in business confidence increase valuations in stocks. Here trend followers buy in as the market consistently makes new highs and the investing public is filled with increasing confidence.

Tides, Waves. . . and Ripples 41

Stage 3: Excess.Speculation is rampant and pushes the market ever higher.

Valuations are excessive and the general public is fully involved in the market. Everyone believes that a new era is at hand and all are overly optimistic regarding the future. This sounds like Alan Greenspan’s “ir-rational exuberance” and will be familiar to all who were watching the market in the late 1990s into the year 2000.

For Dow Theorists, the primary trend bear market, or “panic” as was still the accepted terminology in Charles Dow’s day, also has three stages that mirror the three stages of the primary bull market.

Stage 1: Distribution. This is the point where the “smart money” starts to move out of stocks; but the majority of investors are still willing buyers because they feel that the market still has a long way to go on the upside. The market, however, starts to look tired.

Stage 2: General decline.This downward trend is characterized by deteri-orating business conditions, falling revenues, and shrinking profits.

Stage 3: Despair. At this point, there is no good news around. The economic outlook is bleak and nobody wants to be involved with the stock market, which appears to be a loser’s game. There is a generally pervasive lack of confidence in the future. The de-spair stage continues until all of the bad news is fully priced into stocks, then the cycle can begin again. It is at this stage that fi-nancial reporting may adopt a very negative tone on the prospects for the market. The most often quoted example of this is the Business Week cover story of August 13, 1979, “The Death of Eq-uities,” which foretold the forthcoming demise of stocks as the Dow languished at around 840, a prognosis that clearly now seems somewhat premature with the Dow above 12,000, as of February 28, 2007.

Peaks and Troughs

Dow Theorists seek to identify the primary trend using what is known as peak and trough analysis. An uptrend is detected by prices forming a series of higher highs and higher lows. A downtrend is characterized by prices setting a series of lower highs and lower lows. Additionally, it is also an important part of the theory that the Dow Jones Industrial Average and the Dow Jones Transportation Average both confirm the trend. Until 1897, there had been just one stock average maintained by Dow Jones & Co., but at the beginning of that year separate averages were established for rail-road and industrial stocks. Today’s equivalent of the early Rail Average is

the Dow Jones Transportation Average. It is normally to be expected that the Transportations lead the confirmation of any trend, as stocks in that index are especially cyclical and, by definition, highly susceptible to eco-nomic changes. However, Dow Theory holds that the certainty of a new trend can only be considered to have been firmly established when both averages confirm each other’s evidence of it.

Trading volume is also said to provide additional evidence of which trends are in place. “A market which has been overbought,” according to Rhea, “becomes dull on rallies and develops actively on declines; con-versely, when a market is oversold, the tendency is to become dull on de-clines and active on rallies. Both markets terminate in a period of excessive activity and begin with comparatively light transactions.”⁷

As previously mentioned, the Dow Theorists in no sense shy away from looking at what they are trying to achieve as “speculation.” However, they look rather askance at short-term speculation/trading. Rhea voices the rather low level of importance he places on the ripples in his Story of the Averages, asserting that the study of the ripple fluctuation, or the minor trend as it is also termed, warrants only 10 percent of serious study time.⁸ As Dow Theorists see it, the study of ripple fluctuations provides little pre-dictive information from the price data to point to the trends that truly interest them, the primary bull and bear trends.

For Dow Theorists, the principal reason that there should be any ex-amination of short-term fluctuations is to ascertain whether these start to form patterns over time, which may be valuable in helping to identify the more important primary and/or secondary trend. One of the patterns that may be formed by ripple fluctuation movements is a so-called “line.”

Hamilton many times referred to “lines,” which were really trading ranges where the market moves sideways for two to three weeks or longer. Ac-cording to Dow Theory, such trading ranges indicate either accumulation or distribution, but which one it actually is will only become apparent once the market breaks out to the upside or downside.