The Dow Theory…..Did it Fail?

By: Tim_Wood

As the Industrials topped out in 2000 and plunged nearly 38 percent into the 2002 low, every indication, according to Dow theory, was that an extended secular bear market had begun. Also, because of the Dow theory phasing along with the normal bull and bear market relationships, as the rally from the 2002 low began, indications were that this was the rally separating Phase I from Phase II of a much longer-term bear market. So, what went wrong? In this article I want to examine the chain of events that have transpired since the 2002 low and in doing so look at where we are and the lessons that have been learned.

Let's begin with a very very basic and non-subjective principle of Dow theory. According to Dow theory, confirmation of a Primary up trend occurs when both averages better their previous “Secondary High Point.” At the opposite end of the spectrum, confirmation of a Primary down trend occurs when both averages fall below their previous Secondary Low Point.” When I say both averages I'm talking in Dow theory terms and this refers to the Industrials and the Transports only. The Utilities were never and have never been a part of the Dow theory. In fact, the Utilities did not even come into existence until 1929, which was some 33 years after Dow developed the Industrials and what at the time was known as the Rails. With this all being said, let's turn to the chart below in which I have marked each of the Secondary Low Points since the 2002 bottom.

Beginning with the 2002 bottom, the Industrials advanced into November 2002 and the Transports moved up into January 2003. From these highs the averages moved down into the March 2003 lows, which marked the first joint Secondary Low Point on the chart above. More importantly, the March 2003 lows marked the first Secondary Low Point following the joint Secondary Low that occurred in October 2002. From the March 2003 lows the averages advanced into June 2003 and in doing so they both bettered their previous 2002 Secondary High Points, which are labeled with a “1.” At this point, based upon price action alone and the most basic concept under Dow theory, the Dow theory told us that the Primary Trend had turned up. It was the longer-term indications surrounding the 2000 top and the phasing aspects of Dow theory that suggested this advance was still a counter-trend move. As a result, a conflict of such was born.

Nonetheless, the market marched higher into the next joint Secondary High Point in January 2004. Note that the Transports moved down into their Secondary Low Point in March 2004 and by June had once again moved above the January Secondary High Point. All the while, the Industrials spent most of 2004 lagging behind and by doing so created a Dow theory non-confirmation for most of 2004. Then, in December 2004 the Industrials finally got back into gear with the Transports and the next joint Secondary High was made in March 2005. Again, this reconfirmed that the averages were “in gear” to the upside, but it was the longer-term indications surrounding the 2000 top that suggested this advance was still a counter-trend move. The next joint Secondary Low Point then followed in April 2005.

From the April 2005 Secondary lows, the averages once again began moving up into their 4 th Secondary High Point, which also served as the 4 th confirmation that the Primary Trend was up. But, again it was the longer-term indications surrounding the 2000 top that continued suggesting this advance was still a counter-trend move. The next joint Secondary Low then followed with the 2006 summer lows. It was then in October 2006 that the Industrials finally moved above their 2000 all time high. But, in the wake of these historic new highs, the Transports lagged and this in turn created yet another Dow theory non-confirmation. However, with the bettering of the 2000 high, back in October, it had nonetheless become undeniable that the averages were still operating within the context of the great secular bull market that began back in 1974. Yet, the Dow theory non-confirmation that began at the 2006 summer and Secondary Low Point continued. However, on February 13, 2007 the Transports bettered their May 2006 Secondary High Point and in doing so this put both averages back “in gear” and served to reconfirm for the 5 th time since the 2002 low that the Primary Trend was up. The last joint high by the two averages occurred on April 25, 2007 . Since that time we have seen the Transports lag, but it is far too early to read anything into this short-term non-confirmation.

Now that we have stepped through the chain of events from the 2002 low to present, one has to ask, “What went wrong and has the Dow theory failed?” Before I answer that question I want to turn to a couple of quotes by Robert Rhea, who wrote more on the Dow theory than any of the old time theorists and is probably my favorite of the Dow theory founding fathers. In Robert Rhea's work titled The Story of the Averages , it is beyond apparent by the numerous examples that confirmation of a Primary up trend occurs when both averages better their previous Secondary High Point. To the contrary, confirmation of a Primary down trend occurs with a joint violation of the previous Secondary Low Point. Robert Rhea further states, “Under Dow's theory the primary trend, once authoritatively established as bullish, is considered to be continuing in force until negated by a confirmed bearish indication such as would be the case when, after a reaction of full secondary proportions in a bull market, a rally fails to lift both averages to new high ground, and a later decline carries both averages below the preceding secondary low.”

So, according to these basic rules of Dow theory as are presented in the The Story of the Averages , the Primary Trend turned up, or in Rhea's words it was “authoritatively established as bullish,” way back in June 2003 when the 2002 Secondary highs were bettered.

But, and this is a huge “but,” also in late 1999 both averages moved below their previous Secondary Low Points establishing that the Primary trend had turned down. Following that the Industrials moved higher into January 2000 and a massive non-confirmation was born. Then, from there the averages broke down hard into the 2002 low. Furthermore, based on the phasing aspects of Dow theory it appeared that the decline into 2002 was the initial leg down of a much larger secular bear market. So, that being said, the market phasing simply appeared monumental and to be ominous. Thus, between the confirmation of the Primary up trend in 2003 and the overshadowing phasing aspects of Dow theory surrounding the 2000 top and the decline into the 2002 low, it appeared that the phasing carried more weight.

As it turned out, making such assumption was in error. The problem was not with the Dow theory itself. The establishment of the Primary trend should always carry the most weight. Again, Rhea stated, “ Under Dow's theory the primary trend, once authoritatively established as bullish, is considered to be continuing in force until negated by a confirmed bearish indication …” Once the 2002 Secondary high was bettered in 2003, the Primary trend turned up and to date nothing has occurred to negate it.

Sure, there was intervention by the Fed. They cut interest rates and pumped the heck out of the money supply and it pretty much goes without saying that because of that intervention the market is where it is today. I'll also add that the Fed did these things because they too knew the grave danger that the market faced. Don't think that they weren't aware of the Dow theory phasing. Their efforts were not just for kicks. Also, along the way there was a number of Dow theory non-confirmations that developed and those non-confirmations were indeed warnings, no doubt about that and yes more intervention resulted. But, if we go back to this rule, price and price alone has proven to be what matters most regardless of what is driving it or what we may think another aspect of the market may be telling us. All that matters is the establishment of the Primary trend and until a move below a previous Secondary Low Point occurs, this basic rule states that the existing Primary up trend is “ considered to be continuing in force until negated by a confirmed bearish indication. ”

So, the problem was that because of the beyond ominous looking dark cloud that the phasing was casting at the time, the phasing was given far too much weight and the basic rule surrounding the establishment of the Primary trend was made secondary. But in fairness, this was a very very easy and logical assumption to have made given the extreme negativity of the events surrounding the 1999 to 2000 timeframe and the decline that followed. I sincerely believe that the market had slipped into a secular bear market and that the phasing was also correct. But, I also believe that the liquidity campaign to save the stock market was successful at pulling the market from the grip of the bear. As a result, it has been proven that following the developments surrounding Secondary High and Low Points is by far the single most important aspect of Dow theory. In my opinion, this proves that everything else is secondary.

When looking at the work of Robert Rhea and his predecessors they did speak about market phasing. But, the vast majority of these great Dow theorist's work was centered around price movement and whether or not a movement was Primary or Secondary in nature. By comparison, much less attention was given to phasing. In effect, the price action surrounding Secondary High and Low Points is really nothing more than a method of using intermediate-term price action as a means of confirming the longer-term trend. The lesson here is that the Dow theory was in fact correct and that everything is secondary to the establishment of the Primary Trend. So, that basic Dow theory principle that was defined over a hundred years ago must never be overshadowed.

I want to add that obviously hindsight is always 20/20, but the point here is that I have heard many proclaiming that the Dow theory was wrong. Fact is, the Dow theory was right. It was not giving the proper weight to one of the very basic principles upon which Dow theory was founded that was the problem.

I want to add that this in turn also tells us that the most important timeframe for the market is the intermediate-term. The long-term can evolve and morph and the short-term can often consist of too much noise. This is also a lesson that is consistent with my cycles work. That said let me make it perfectly clear that cycles are not a part of Dow theory. However, here too it has been proven that the most important timeframe is the intermediate-term. The long-term methods yield what I call the “over the horizon” stuff, which can change and/or morph. It is for this reason that I developed the intermediate-term Cycle Turn Indicator (CTI) several years ago. Even with the confusion surrounding the Dow theory and the statistics on the 4-year cycle, this indicator has continually signaled the proper direction of the market.

The CTI turned down last May yielding a sell signal in equities and following that signal the decline into the June/July lows began. At those lows, the CTI turned up. I had my doubts as to how far that rally would go, but with this indicator up, the green light was given. As a result, the Industrials moved not only above their previous Secondary High Point, but also to new all time highs. This indicator remained positive until December 2006. In yet another recent example the CTI turned up the week of January 5, 2007 on the Transports. Remember, this occurred with the Transports lagging and a Dow theory non-confirmation in place. Yet, the indicator was correct. More recently, the CTI turned up the week of March 23, 2007 on the Industrials and I then told my subscribers that a buy signal had been triggered and that in spite of the statistics surrounding the 4-year cycle everything else was secondary to this indicator and its signals. Personally, I continue to be amazed by the CTI. It called the tops on oil and gasoline last summer as well as the lows in January. Point being, just as the Dow theory has proven, I too have also found from my cycles work that the intermediate-term trend and identifying the intermediate-term trend changes is without a doubt the most important aspects of any given market. So, it is my belief that we should always understand what the long-term over the horizon stuff is telling us, but we must always give more weight to the intermediate-term, the price movement surrounding Secondary High and Low points, and the CTI.

I have also begun doing free Friday market commentary that is available to everyone at www.cyclesman.com/Articles.htm so please begin joining me there.

By Tim Wood
Cyclesman.com

© 2007 Cycles News & Views; All Rights Reserved
Tim Wood specialises in Dow Theory and Cycles Analysis - Should you be interested in analysis that provides intermediate-term turn points utilizing the Cycle Turn Indicator as well as coverage on the Dow theory, other price quantification methods and all the statistical data surrounding the 4-year cycle, then please visit www.cyclesman.com for more details. A subscription includes access to the monthly issues of Cycles News & Views covering the stock market, the dollar, bonds and gold. I also cover other areas of interest at important turn points such as gasoline, oil, silver, the XAU and recently I have even covered corn. I also provide updates 3 times a week plus additional weekend updates on the Cycle Turn Indicator on most all areas of concern. I also give specific expectations for turn points of the short, intermediate and longer-term cycles based on historical quantification.

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