The Dow theory :
We saw earlier that the Prices are the net result of the expression (by all kinds of players, big and small) of all the known news and all the known views within the market. Since there are so many different variations in the expressions we have substantial differences in prices and since this expression process occurs through the time that the market is open, we have the prices moving up and down continuously.
Technical analysis is defined as the study of market action principally through the medium of charts. When we say market action, we address the two variables that are present within the market-the Price and the Volume. It is almost like the chicken-and-egg story with prices and volumes. You truly cannot put a finger on which came first or which moves the other. Let's just say that it is a feedback loop, which continues into perineum. So a study of Technical analysis would actually involve the study of prices and volumes. Now we all know that if something has to be studied then it has to be organised in a structured manner. Technical analysis is all about this organisation so that looking at prices becomes a simplified affair.
The first guy to attempt this- though not exactly from a stock market point of view - was Charles Dow, back in 1897 when he was the editor of the hallowed Wall Street Journal. Dow was the first to come up with some kind of structured look at prices and to suggest that there could be some merit in looking at price movements as they would signal us about the way things are. Dow looked at it from an angle of forecasting the economy rather than the stock market. He wrote about these concepts as editorials in the paper. It was his successors at the paper- people like Hamilton and Robert Rhea-who later put together these editorials in the form of a formal theory and gave it the name Dow Theory of markets. This stands to this day and is considered the grand daddy of all stock market theories.
Most of the later developments in technical analysis occurred as a follow up study of the tenets included in the Dow theory. So let's just go right ahead and examine what these set of tenets are. Dow stated them as follows :
The Averages Discount Everything : Prices discount everything that is known about a stock. The averages-the ones Dow refers to are the Dow Jones Industrial and the Dow Jones Transportation Index (or the Rails)-are nothing but a simple average of the prices of the stocks from the industrial and transportation sectors. During those days, the US markets had a number of Railroad stocks also listed and these were the two prominent indices. Dow also essentially came to the same conclusion that the market, ultimately, discounts everything because it is the only place where every kind of player is able to express him.
Prices move in Trends : Dow suggested that prices have a tendency to move consistently in the same direction for long lengths of time. These he expressed as Trends. We are all aware of what trends are-we often talk about them as being either bullish or bearish trends. What it really refers to is the consistent movement of prices. When markets are moving about aimlessly, they can be said to be random but if there is a certain consistency in the direction of price movements, then we say that they are trended.
Trends were classified by way of Direction-Up, Down or Sideways or by Time-Long Medium and Short. While the classification by direction was more generic, the classification by time was taken to be more specific. They were given specific names and extent. Hence the long term was called Primary Trend and was expected to last more than one year. The medium term was called the Intermediate Trend and was expected last from between 3 weeks and up to 3 months while the short term was called the Minor Trend and was expected to last up to 3 weeks.
However, under present market conditions, these definitions of trend times have become way off. Now, everyone thinks of long term as being equal to the original time defined under Minor! So the best way to state this would be to say that every person should try and set his own trend timing definition.
Dow defined a trend as a sequence of Higher Tops and Higher bottoms. In other words, prices have to move in such a fashion that every rises will exceed the previous peak while subsequent declines will hold above the previous declines. Pictorially, it will look like this :
The logic of this is very sound. Unless people are willing to pay a greater premium the prices cannot rise further. And people will pay a higher premium only when they perceive that there are even higher prices down the line. This can happen only when the underlying fundamentals are sound. Hence a sequence of higher tops will indicate that the perception of the underlying set of numbers is deemed to be positive. A higher bottom would form when the people are in a hurry to buy thereby preventing the stock prices to trade down to where they had been earlier. This also suggests that there is a change in the perception about what the stock is worth. The exact reverse happens when the stock is showing a sequence of lower tops and bottoms. People are seen to be in a hurry to discard their holdings. This can only happen when there is something adverse in the perception about the stock. Therefore a clear sequence of lower tops and bottoms would be a bearish signal.
Trends have phases :
This is a further delineation of how the price trends are to be studied. By giving a greater emphasis on the different aspects of a trend, Dow chose to draw a clearer picture of what is happening within the markets. Essentially, any trend has three phases :
A phase of accumulation : where the insiders buy up the stock and begin sponsoring a new rise. Quieter price movements often characterize accumulation but a closer look would reveal that higher tops and bottoms would be recorded at a minor level as insiders begin to absorb all the stocks on offer.
The phase of accumulation is then followed by a phase of Rapid Advance. This happens when the broader market becomes aware that there is something new happening in the stock and begins to participate. Maximum price moves occur in this phase.
This is then followed by a phase of Distribution. Once the price targets are achieved, the stocks are then sold off to the maximum number of people, thereby exiting the positions built up earlier during accumulation. Many times distribution occurs over a period of time and may be part of the last rise as well as the first fall.
On the downside, the sequence begins with distribution, is then followed up with a phase of rapid decline and is then succeeded by a phase of Rapid Decline and then terminates with a phase of accumulation.
Volume must expand in the direction of the main trend: Addressing the second variable within the market, Dow stated what to most would seem obvious that every directional move in the market must be accompanied by volumes. By making it a rule Dow ensured that we would have a definitive way of checking for true and false up and down moves. One would have to make comparative studies between two legs of advances (or declines) on the volume patterns that they exhibit. Depending upon what is seen, one can then draw a conclusion that either the market is moving ahead with volumes accompanying advances or not. A rising market trend can only persist if there are more and more people willing to invest in that direction. So a rise, which does not have volumes, is suspect and liable for reversal.
Averages must confirm : Dow made this as a safety tenet. By stating that the sequence of higher tops and bottoms should be seen in more than one average (industrials as well as rails) he was just ensuring that the uptrend that one is supposing has a stronger foundation. The basis of conclusion was that what was evident across a wider canvas has a lesser probability of becoming wrong.
Reversal Signals : Dow stated that a trend is in existence until there is an evidence of its reversal. This may seem a bit circular but in reality, it is very clear what Dow is attempting here. He is giving us a clear rule that prevents us from becoming subjective about the markets. This tenet says to us that until there is a new sequence of lower tops and bottoms, the earlier sequence of higher tops and bottoms should be deemed to be in existence. This way we will be prevented from taking an improper trend consideration.