Dow Theory

Hello all. The markets rebounded from mid day lows today to end in the green for the S&P and the Dow, but the Nasdaq ended down just .21%.

The good: Philadelphia-area manufacturing index rose unexpectedly to 8.5 this month from minus 17.5 last month. This shows signs of a slowly growing economy. Labor dept. said new applications for unemployment dropped to 403,000 last week which means less people are being laid off. Libyan leader Col. Gaddafi was killed today. Hopefully some stability and democracy can find its way into Libya.

The bad: Sales of previously-occupied homes fell 3% last month. The housing market is clearly not strong right now. More importantly, the news from Europe was mixed to bad today. According to a Wall Street Journal article, " Europe's efforts to deliver a comprehensive plan to resolve the euro-zone debt crisis were in danger of unraveling Thursday as disagreement between Germany and France over virtually every point in the plan forced the 27-nation bloc to concede that a much-anticipated summit of European Union leaders on Sunday will produce no concrete results." Also the protests in Greece over the austerity measures have turned violent over the past few days. (Doesn't necessarily affect the markets much.)

Probably good: The Greek parliament passed painful austerity measures to reduce spending, their deficit, and other programs. Although I feel for those in Greece who will be adversely affected by this, things could not remain the way they were.

DOW THEORY:

According to Investopedia, "A theory which says the market is in an upward trend if one of its averages (industrial or transportation) advances above a previous important high, it is accompanied or followed by a similar advance in the other."

According to Wikipedia there are 6 basic tenets of Dow Theory: The market has three movements, market trends have three phases, the market discounts all news, stock market averages must confirm each other, trends are confirmed by volume, and trends exist until definitive signals prove they have ended.

A fundamental aspect of Dow Theory is applied in current day to technical analysis. This can tell a short, mid, or sometimes long term investor/trader when to buy and sell to avoid significant losses. It goes as follows:

Markets and the stocks that are within move in trends. Up-trends are signaled by the stocks that move above a previous low, and then go on to set their own low, and continue to go higher from there. This process then repeats itself. To understand what I am saying, have a look at this chart of the Dow Jones Industrial Average from 2 years ago on this day until today: 

 

 From May 2010, to July, 2010, the Dow was in a downtrend. In July 2010, it began to rise from a low and went on to set a HIGHER low than the previous low. This HIGHER low was made in about mid July. It then went on to move higher and then set a LOWER low in September. This would be the start of a downtrend, but as we see, it reversed quite quickly. The LOWER low wasn't very much lower, it was actually almost the same number, so less significance would be paid to that. In retrospect, we can see it was just a blip in the much longer uptrend. The market continues to rally until November when it cools off a bit and makes a HIGHER low in December, 2010. This is part of the Dow Theory of technical analysis and it can help you make better decisions. Always buy in an Uptrend, and avoid downtrends. (Of course money can be made any time.) The Dow Theory presents a good framework for risk-aversion. As you can see now, the Dow Theory doesn't help us much, as we are stuck trading in a tight technical range. 

There is much more to the Dow Theory but this is one aspect that can help you make better informed trades on a technical basis. I would not advise making trades based on technicals solely. 

One last thing. If you are following a stock that you own in an uptrend and want to avoid losses, you can set your stops using this aspect of Dow Theory. The way you do this is to place stops at approximately 1 ATR (average true range, the average range the stocks trades in one day) below the most recent HIGHER low. If this is confusing, please comment. I'd post more images but I have to study for midterms. Bye all.

Cheers,

EZ