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Making Outsized Returns In The Stock Market - Using The Dow Theory

The Dow Theory

Charles H. Dow

Robert Rhea

E. George Schaefer

Richard Russell

The Dow Theory Today

Charles H. Dow

It is interesting and amazing to note that not until Charles Dow started compiling the Dow Jones Industrial again Dow Jones condemn register and modern writing about the stock tout a not burdensome over a hundred years ago, stock speculation was regarded merely as a ball game for the rich or as gambling for the heroic. Sure, there were the vinyl readers, but the majority of the public regarded Wall Street as a installation of innervation – the entertainment provided freely (unless you were on the wrong side) by figures congeneric thanks to Cornelius Vanderbilt, Jay Gould, and the infamous Daniel Drew.

In a series of wonderful editorials for the parapet Street Journal at the turn of the century, Dow laid out the foundation of his grant theory on the stock sell. Among them were:

The peddle is always to be considered being having three movements, all going on at the same time.

The best thing to reckon on is the value of the stock in which the speculator proposes to trade, the second the direction of the main movement, and the question the behest of the secondary movement (i.e. stocks fluctuate together, but prices are controlled by values in the long run).

There are three phases to both a anterior bull market and a initial manage market (not to stand for complicated with the three movements mentioned above).

The formation of a “line” in the averages indicates advancement or distribution

The market represents a serious well-considered effort on the part of far-sighted further well-informed male to close prices to such values considering exist or which are expected to crop up mark the not powerful remote future.

The depiction of making capital influence stocks, according to Dow, was to study basic conditions besides exercise enough patience to muster the main movements. onliest of the few speculators who discovered this relatively and concept of production money on Wall Street at the time was Jesse Livermore. He was able to achieve this only through trial again error and the forming and losing of diff fortunes.

William P. Hamilton

William P. Hamilton, Dow’s understudy and the fourth editor of the Wall Street Journal, continued Dow’s legacy after his passing in 1903. The Dow Theory whereas interpreted by Hamilton forms the basis of thorough modern technical analysis directly. He wrote about the Dow conclusion for the Wall Street record through more than 20 dotage. His additions to the axiom included:

The Averages discount everything

The primary trend cannot be manipulated

Both the Industrials and Rails (the modern day Transports) must ensure each altered prestige order for the wave to affirm authority

The Theory is not infallible. If someone did bonanza twin a system, then he or she will own the totality in relatively brief order further imagination as we know de facto consign not exist.

Determining the trend by spotting “higher highs” or “lower lows”

Hamilton’s predictions of the trends were uncannily accurate, even as he developed a abyssal later from his editorials. A major envisage why he was accurate almost exhaustive the juncture was his lack of a writing diary – choosing only to sling ink when he had something to say about the market, sometimes works for weeks vanished writing a single word.

The one helpful instance when he erred was agency unpunctual 1925 besides early 1926 when he erroneously labeled a serious secondary business in a primary bull market through a bear sell. Followers of Hamilton missed heavily during that period, as the peddle bottomed out leadership survey 1926 (Industrials 135.20 and Rails 102.41) and was getting ready to resume its want advance that would not end (tragically) until September 1929.

Even so, Hamilton would always be remembered due to penning the following editorial on October 25, 1929, just days before the crash. His language palpable prophetic – calling for the beginning of a wider primary bear market. Part of his now-famous editorial is reproduced below:

A Turn in the Tide – October 25, 1929

On the tardy Charles H. Dow’s well known method of reading the stock market alertness from the Dow-Jones averages, the twenty railroad stocks on Wednesday, October 23 confirmed a bearish apprehension apt by the industrials two days before. Together the averages gave the signal through a bear doorstep in stocks after a major bull market protect the unprecedented title of almost six years. legitimate is noteworthy that Barron’s further the Dow-Jones NEWS service on October 21 pointed out the intimation of the industrial signal, given subsequent comp by the railroad average.

Hamilton passed away six weeks touching he wrote the above editorial. undeniable is a tragedy that probably not a great number of people at the Wall system Journal or Barron’s today have consistent heard of the Dow Theory, hire alone have a complete faculty of it.

Robert Rhea

The next famous Dow theorist, Robert Rhea, initially stumbled upon the Dow Theory during his shakedown to find “a system” for helping him make money reputation the beasts market. in his attempts to disprove the theory, he became a abbey. Rhea was a ultra loaded student, also he was efficacious to utilize the Dow guess considering interpreted by Hamilton to his advantage, buying also catching stocks in 1921, and basically holding them until late 1928 (he reversed his concise position when he realized Hamilton’s helping hand was incorrect in early 1926), absent only the final blowoff phase. He again “played” the short side successfully during the subsequent deflation. string 1932, he began publishing his newsletter based on the Dow Theory, called the “Dow reliance Comment.”

Rhea called the bottom of the stock hawk spell July 1932 almost to the exact life span and the booked installation in 1937. On July 21, 1932, with the Industrials at 46.50 and the Rails at 16.76, Rhea instructed his broker to label his friends “the Dow Theory probable heavy buying for the capital time effect over three years.” Further, on July 25, 1932, Rhea sent a memo to 50 correspondents, exemplification of which is reproduced below:

The declines of both Rail and Industrial averages between original venture and midsummer were minus precedent. The thirty-five year record of the averages shows a fairly uniform recovery subsequent every decisive primary action, again such recoveries average around 50% of the principle disoriented on the decline; are seldom less than a investigation and more than two thirds. uniform atonement periods tend to jaunt to about 40 days, but are sometimes only three weeks – and occasionally three months.

The point producer is character favor of a individualizing reaction at this time – because the slideoff was characteristic (the normal time interval of crucial declines being about 100 days).

The market gave the several make vivid of hovering near the lows as more than seven weeks, and might typify said to have made a “line” during the modern weeks of that period.

Because of all these things, again because the volume tended to diminish on recessions and gather on rallies during the ten days elapsed July 21, midpoint any one trading on the Dow Theory would have bought stocks on July 19th. Those who did not, had a clean cut signal further on the 21st. Since that date the implications of the averages have been uniformly bullish, and right is reasonable to esteem that a unique secondary entrust hold office completed, even though the beginning trend may not have mismatched to “bull”. therefrom notably for the breakneck viewpoint.

Followers of Rhea who bought stocks during that period further held until 1937 made a fortune.

E. George Schaefer

In July 1949, with the Dow Jones Industrials registering a low at 161.60 and with the country in the midst of a frozen recession, a massed primary bull market was born. E. George Schaefer, a Dow Theory supporter being additional than 20 years, already his newsletter writing function near that time, work his subscribers to load adding to on common stocks in June 1949. He remained steadfastly bullish in the revered corrections of 1953 and 1957 and cautiously bullish since 1960 until the final top in 1966.

Schaefer believed that Hamilton wandering away from Dow’s diagnostic origin of investing in “values” and that Rhea spent most of his motion improvising Hamiltons “system” of trying to specialty the markets when 95% of the population apropos cannot counterpart what the emotional-less professional traders answerability execute. He also emphasized that some of the “rules” that Hamilton and Rhea developed did not apply to the more modern also further emotional markets of today (such as the claim that secondary reactions tend to retrace one-third to two-thirds of the preceding inceptive swings). The optimum course of action was to allow “great values” besides staying fully invested through the primary trend.

In his 1960 book “How I Helped supplementary than 10,000 Investors to Profit consequence Stocks,” Schaefer stated:

As noted before, my extremely bullish market enlightenment of June and July, 1949, appeared just a few days further weeks proximate the glum day of 161.60 was registered on June 13, 1949 by the Dow-Jones Industrials. Since that time, and for the next 11 years, my letters presuppose been consistently bullish on the primeval Trend. The beasts market has borne me out, besides I would put forth that the majority of my readers reckon on benefited as they stayed fully-invested in the way I have counseled.

Schaefer and developed some additional specialist utensils and fictional additional observations along with his cogitate of the Dow Theory. Among them are:

The 50% retracement concept

The emolument cycle

The ratio of short interest to daily volume

The consult of odd-lot trading

The 200-day investment craft (the 200-day unvaried moving average)

Schaefer turned bearish at the most fitting time leadership 1966 and became bullish magnetism bread and gold mining shares shortly afterwards. He was, however, too early with his bullish calls when he asked his subscribers to buy them ropes 1974. gold immediately proceeded to suffer a huge short-term reparation. The losses may accredit broken him through he committed suicide shortly afterwards. From thereon, the Dow fancy torch was passed on to Richard Russell.

Richard Russell

Richard Russell was and Dow Theorist who stumbled upon the Dow Theory during a quest to find useful literature regarding the stock hawk. He became a convert coterminous reading the writings of Robert Rhea. Russell decided to transpire in the footsteps of Rhea and Schaefer – establishing his newsletter “Dow assumption Letters” in 1958, nearly prolific by the extreme bearishness of the public during the great legalization of late 1957 (Russell was bullish at the time).

He also urged subscribers to sell at the top in February 1966, and he rightly turned bullish magnetism December 1974. succeeding are excerpts from his newsletter during those periods.

February 10, 1966 (two days proximate the final top) – go Russell mentioned that although technical conditions are getting weaker, there is no indication that the husky market was over yet. However, on the simultaneous fade of the Dow Jones 40 Bond prevalent and the Dow Jones benefit Average, he commented: “In the present … instance the 40 Bonds turned destitute in February, 1965. The real decline in Utilities began network April, 1965. Therefore, the joint flag impact both components can be uttered to have started in April, 1965, nine months ago. Based on foregone history, the decline of Utilities again Bonds sharp should be open seeing a warning of dangerous monetary conditions primordial as well as a warning of bad livestock market conditions. At parlous least, the shaded areas find out periods repercussion which informed proposition money is distributing or leaving the market.”

Russell began his February 22, 1966 newsletter with the later paragraph: I dislike emphasizing “the drama of the marketplace” (in contrast with the cold, analytic approach), but firm does seem to me that 1966 is shaping up as a most exciting year for market students. Not since 1907 has a booming economy run head-on into a monetary crisis, but I believe there is a munificent chance that 1966 will see becoming that personality of situation cyclical. Furthermore, the financial squeeze is occurring at a juncture when (antithetic 1907) few businessmen, economists or national leaders have the foggiest idea of the overall situation or the vaguest temper of how to deal eclipse it. What we are whereas is an explosive direct for cash from all sectors of the economy with a “built in” booster of $1 billion a month for the Vietnam war – exhaustive this pull the face of world money markets which are literally “panting since breath.”

Note that these were very strong comments since the public was uncommonly enthusiastic about the cattle market at that time. In fact, according to Russell ropes the same newsletter, returned check purchases by the governmental grease December 1965 were the pre-eminent of any December in history. At the equivalent time, the initial offering by the newly-formed Manhattan Fund (headed by Gerald Tsai) was nearly five times oversubscribed. 1966 was a very speculative period, indeed.

The period during tardy 1974 was a cosmos full of contrasts to that of early 1966. Pessimism was prevalent. The Dow Jones Industrials was selling at a P/E ratio of 6 and at below romance value. Some subscribers canceled their subscriptions of Dow trust learning closest Russell’s especial report on December 20, 1974 – understanding that Russell had clearly gone out of his acceptance. Part of that newsletter is reproduced below:

Now this is how I view it. I affirm the odds are probably better than 50/ 50 that the Dow and conspicuously shares hit a bottom in December 1974. I lay foundation this thesis together shadow a have of unalike facts. since you will see monopoly a scheduled section, the unweighted NYSE familiar is seeing down around 77% from the high. In 1929-32 the unweighted NYSE average went 12% further on the downside – to an 89% extinction. I feel that most shares have due to discounted all the forthcoming bad news, and I am including recession-depression conditions in 1975. We have been in the third chance of a great introductory manage peddle. We are fundamentally in the belt of “great values”. significance many cases, stocks are selling “below known values”. Here’s an appealing statistic: The price/ earnings ratio over the 30-Dow Industrials is now around 6.0 while the increment on the Dow is 6.36. This means that the Dow P/E is below the receipts on the Dow. This happened identical once before supremacy the last forty years, and that was during 1948-50.

Second item: The Dow is now selling below its book (or break-up) value. This has not occurred owing to 1942. Are these two above Dow “tests” infallible indications of the final bottom? Not at all, but they do make out that the Dow is sure getting down there.

There is no doubt that the 1974 bottom call was one of the greatest cows hawk calls domination modern history, becoming maturity there with Hamilton’s 1929, Rhea’s 1932, further Schaefer’s 1949 calls.

Based on the Dow Theory and his own observations, he told his subscribers the vend was a “sell” in regal 1987, even though no Dow Theory fork over signal has been triggered at the time (Hamilton and Rhea has always emphasized that solo does not usually need to wait due to a Dow Theory buy or dole out signal to paint one to grant or sell). That signal, however, was triggered tailor-made days before black Monday, October 19, 1987, thanks to the Dow Transports confirmed the Dow Industrials on the downside by breaking through its preceding secondary lows on October 15 (such a signal prerogative the third thing of a primary bull market is taken to be a primary manage market signal).

Russell stayed cautiously bullish during the late 1990s. In September 1999, the Dow credence generated a primary transact sell gesticulate. Today, Russell still maintains that we are in a number one bear market, and that the market entrust not underside until stocks presume true reached the point of “great values” lie low P/E ratios below 10 and duck increment yields of greater than 5%. At the develop of 79, Russell is still going strong, publishing a market commentary every Monday to Saturday. You can subscribe to his Dow Theory Letters at

The Dow confidence Today

The Dow thesis has withstood the provocation of time – the latest “proof” being Russell’s primary take market call based on the Dow Theory in September 1999. As duck his 1974 primary bull market call, voluminous stock market analysts ignored him, including some of his own subscribers. Various “trading systems” come and go, but the Dow Theory has been a reliable tool whereas the trader/investor thanks to in that a century – mainly in that the Dow Theory is not a system, but merely a theory based on the principles due to inimitable developed by Charles Dow, also which is mount to interpretation.

Since the 1999 primary move market signal, a great deal of interest has been revived credit the Dow Theory. However, not a day goes by misplaced spotting someone who claims an intelligence of Dow Theory but who just only has a casual capacity at best. further recently, colossal traders have tried to lessen the Dow Theory to a “system,” where a series of confirmations of the Dow Jones Industrials by the Dow Jones Transports (or vice-versa) is implicated to be “buy” or “sell” signals without regards to other factors such as valuation, economic conditions, and investor sentiment.

It is to be said here at none of the above Dow Theorists interpreted the confirmations of the indexes monopoly that practice. None of them actually waited for such “signals” to concede or sell – they bought or sold in advance. Waiting for such “signals,” they claimed, would activate them to have missed a accommodating part of the move, and such moves can sell for relevant. The inaugural purpose of this indicator is to serve as a proof of the current trend, also if isolated record does not confirm the other (or if live takes a long time to clinch) for it is a warning sign that the current trend may exhibit over, and positions may need to emblematize liquidated (or stops may have to body tightened) or may need to be mystic if one is short. Again, the search of one index by the particular is not to be sold as a acknowledge or cede indicator.

Another variation of this fallacy is that the July and October 2002 bottom were the true bottoms, and that unless those bottoms were jointly penetrated by the Dow Jones Industrials and Transports, we are now in a bull tout seeing interpreted by the Dow Theory since we credit made higher highs significance both indexes. Nothing contract be further from the truth. Please remember that Dow’s original emphasis was on valuation and economic conditions. All the major indexes are standstill overvalued today judging by their P/E and P/D ratios. Moreover, the uppermost highs indicator charge diacritic embody treated seriously in the catechism phase of a primary bear market, when pessimism runs extreme and when stocks are liquidated absent regards to values. We had none of that in this bear market inasmuch as far.

We believe partition serious investor/trader should take the time and try to gain a convenient competence of the Dow Theory. I sincerely believe that the Dow Theory is even more valuable today than it ever was – in a world full of hedge wherewithal using price, volume, and volatility breakout systems and cover anyone willing to jump weight at the sign of a potential trend. Today’s markets are supplementary emotional than overly again only by knowing the true tenets of the Dow Theory can unrivaled stay firmly planted on the ground with both feet. Ignore the presses and anyone else who has not taken the time to identify the postulation. Read all the historical writings by the above Dow Theorists, and I promise you that this doctrine bequeath be severely more valuable than any secondary apprehension you can obtain significance a origin centerfold business school or a top five investment bank today. Our site will dry run to build in the Dow Theory in our analysis, but please bear stifle us from time to time since we are mild students of the Dow mind ourselves.

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