Dow Theory
Posted on 17 May 2009
Basic principle is that the index is “an average that discounts everything” – builds all the market’s moods, information and supply/demand dynamics into its price.
The market then has two states – the bull and the bear – each of which has three phases
1) Bull market
(a) reviving confidence – the index starts to move higher. This occurs where
- there is fundamental undervaluation (low P/E ratio)
- all news is bad
- public is absent from the market
- market may ignore bad news
- looks like a normal bear market rally
- there is general disbelief and then increasing fear of missing out
- its a rally based on anticipation
(b) Increased earnings – the initial rally is confirmed. This is the longest and safest to trade and occurs when:
- fundamental values return to normal
- earnings increases emerge
- good news announced
- each correction ends higher
- sector rotation to growth oriented stocks
- increasing employment
(c) Rampart speculation – the market takes off under the ‘new’ paradigm. This occurs when:
- increased price volatility
- significant fundamental overvaluation
- there are a smorgasbord of new IPO’s and capital raisings
- the public enters the market and day traders emerge
- media coverage increases
- market regulation relaxed
- market is driven by a few stocks
2) Then there are the three phases of the Bear market.
(a) Abandonment of hopes – the first and quick sell-off.
- fundamental valuations still high
- market may ignore good news
- interest rates increase
- maybe other shock news
- IPO’s fail then abandoned
- volume falls away – indicates buying is done or is sustained only by deleveraging
- public may see the correction as a buying opportunity
- public may also panic
(b) Decreased earnings – the long slow realisation that its not going to get better quickly.
- fundamental valuations return to near normal
- market ignores good news
- earnings decreases announced
- No IPO’s
- Sharp sucker rallies followed by new lows
- Public lose interest
- former market leaders fail
(c) Distressed selling – the tail end of the bear market sell-off – it doesn’t have to be quick or in high volume
- significant fundamental undervaluation
- unemployment peaks
- bad news discounted
- no public participation except for forced liquidations
- specialist media disappear
- many bankruptcies and failures
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