Charles Dow's market observations dating back to the late-1800's/early 1900's are still relevant in terms of understanding the major market trends and the key shifts in investor attitudes about the stock market that occur during bull and bear markets and the transitions between them.

I wrote my previous Trader's Corner column about the common understanding of Dow Theory as relating to the need for the Dow Industrials (INDU) and the Dow Transportation (TRAN) averages to 'confirm' each other at new weekly or monthly highs or lows in order to suggest a continuation of the major or primary trend. My last article was number 15 in my basics of technical analysis series and can be found under the Trader's Corner tab on the Option Investor.com home page; or, Dow Theory, Pt.1 can be accessed online by clicking HERE.

The major market trends for the 2009-2010 period are shown below, as interpreted by Dow Theory in terms of the relationship between INDU and TRAN weekly closes:

In this article, Pt.2 of Dow Theory and technical analysis, I'll take up the topic in general of what Dow’s work has to say about the stock market, including in our present era, in terms of bull and bear market cycles and as a foundation for technical analysis.

What follows are the basic tenets of Charles Dow along with some of my thoughts on it. I should also tip my hat to the contribution of Robert Edwards and John Magee, who wrote what many consider to be the 'bible' of technical analysis, Technical Analysis of Stock Trends, for their descriptions and analogy to the 'tide, wave and ripple' effect, although this did not originate with them.

THE MARKET DISCOUNTS EVERYTHING

Dow determined which stocks in his time, which where the ones he included in his first stock averages, best represented the overall market. Every possible fact and factor relating to the price of a stock within the averages is quickly priced into the current traded price of that stock and hence into the averages. According to Charles Dow, this is because the traded price reflects ALL knowledge that exists about the company and its current and future prospects in terms of its earnings power. Even so-called 'insider' information will show up in the price and volume patterns that can be seen by astute observers of the trading in that stock. This group will in turn act on that information and that activity will become apparent to a widening group of speculators and investors. This principle is even truer today, given the extremely rapid and widespread distribution of information that occurs on the financial cable channels and on the Internet.

CYCLES OF BULL AND BEAR MARKETS HAVE THE SAME REOCCURRING PHASES

The point to emphasis here is that the phases of both bull and bear markets, while different depending on whether it's a bull market or a bull market, are similar in terms of two factors: 1.) There are always a group of professional investors who are in the 'know' about the market and 2.) in terms of investor 'sentiment' or attitude about the bullish or bearish prospects for stocks; these attitudes range from disinterested to indifferent (bearish) all to way to mildly or very interested (bullish) in stocks.

BULL MARKET CHARACTERISTICS

A bull market comes after a lengthily and substantial decline in stock values that comes about due to a downturn in the economy or a recession. Major market advances are usually, but not always, divided into 3 phases. These phases are marked by who participates in them and what they are doing in each phase.

1. ACCUMULATION

In the first phase, there is accumulation or buying over a period of time, during which very knowledgeable investors with good foresight about a coming business upturn, are willing to start buying stocks offered by pessimistic sellers who want out. This group of investors will also start to pay higher prices as the willing sellers exit. The economy and business conditions are still often quite negative. The public, and this is mirrored by the financial press, is quite disinterested in the market, to the point of where owning stocks is very unattractive to them and they are out of the market. The people that got 'burned', so to speak, in the last bear market, are disgusted with the market. Sound familiar!? Market activity is modest at best but is picking up a bit on rallies, but this is mostly only noticed, if at all, by professional market participants.

2. A STEADY CLIMB

The second phase is one of a fairly steady advance, but one that is not dramatic. There is a pickup in business and encouraging economic reports as an improving economy leads to a pick up in corporate earnings. This phase is also a phase where money can be made relatively safely, as technical indicators turn positive and there tends to be an absence of volatile trading swings.

3. MAIN STREET ADOPTS WALL STREET

The third phase, which at one and the same time can both be highly profitable and quite risky, is marked by heavy 'public' interest and participation in the market. This might be through proxies, as money increasingly comes into professionally managed mutual funds or into passive index funds. The economic news is good during this period and suddenly front pages of magazines have articles heralding the new bull market. The new issue market gets going as the public now has an appetite for new companies. This is the phase where you might hear banter at parties about the market, how well so and so is doing in stocks and where market-related Internet chat rooms are quite active. Price advances can be huge and volume expands. The more speculative stocks continue to advance but it is here that the blue chip stocks of the most established big-name companies start to lag. Some sharp downswings occur among stocks that fall out of favor. Speculation remains intense as seen in increased option activity, the first-day closes of hot new issues and in the level of buying stocks on margin. The end of this phase is always the same, varying degrees of collapse. This can come after a year or two or after several years has passed from the beginning phase.

BEAR MARKET CHARACTERISTICS

The animal analogy is quite apt, as the bear can both be very fierce and unforgiving, or can just go to sleep for a long period. Bear markets can usually also be divided into 3 phases. That this does not always occur however, as seen in the 1987 bear market that was sharp and steep, but with the decline only lasting two months. After that, there was a slow gradual process of advancing prices during which some bearish sentiment built up and people swore off the market. This phase didn’t reach the typical bearish extremes however, as within 7-10 months the market had recovered nearly half of its October-November decline.

1. DISTRIBUTION

The first phase of a primary bear market tends to be a period of distribution. This period really begins in the final phases of the bull market. It is the phase where selling begins by the type of experienced investors that didn't get overly swept up in the extremes in emotion and price at the bull market peak. This group of savvy investors have more foresight and a more balanced point of view, with the knowledge to understand that company profits have probably reached their peak and that the price multiples paid (P/E ratios) for those earnings are also at extreme levels. They began to sell or distribute stocks to the still eager and willing buyers, especially the public type investors. Volume of trading begins to slow. The public is still in the market heavily but may be a bit frustrated as the rate of increase slows down and not all stocks participate on rallies.

The distribution phase is also one where people who are not usually in the market become buyers of stocks. A story that I used in my book (Essential Technical Analysis) is about a friend of mine who had always only invested in real estate. This person told me near the 2000 top that he had decided to buy some stocks, but had modest expectations; e.g., he 'only' expected or wanted to make 20% on his money. This kind of expectation for stocks, that historically return 10% on a yearly average basis, and had already been going up sharply for months, was the final thing that got me out of the market.

I had noticed the froth in 2000 and that the volume was slipping and profits harder to come by. Then, my friend’s actions and comment became my 'shoe shine boy' event; referring to the famous story of legendary investor Barnard Baruch, who one day got a stock tip from the fellow that shined his shoes. Baruch went and sold his holdings and said that "when shoeshine boys are giving me stock tips, this was the time to sell". I was stuck by a similar occurrence in 2000 at Cantor Fitzgerald, where I was working in 2000, when I overheard one of our security guards on the telephone discussing his trading and going on about this and that stock in a very knowledgeable way like one of our floor traders.

The distribution phase I already knew well, having been through two earlier ones before this last one. The first was in the silver and gold bull market and bubble of the mid to late-70’s. In the final phase, I finally succumbed to the siren call of this market and made an impulse buy of some precious metals. Of course, if I held that investment until now I might have broken even or made a little, but I would have had the purchase price money tied up for a LONG time.

In the late summer of 1986 I was the trader-manager of a stock index futures program at PaineWebber (now UBS) and had the sense to sell my long positions at the opening of what became known as 'black Monday'. However, I didn't have the conviction to be short, where fortunes were made over a couple of days. (Actually the distribution phase had already completed itself by the preceding Friday and we were about to enter a panic.) The other side of my missed profit opportunity in not being short was that at least I wasn't losing money. There were a LOT of losses incurred, especially when investors panicked or traders had to sell to meet margin calls and didn’t hang on for the ensuing weeks and months of recovery.

2. PANIC SELLING

Panic is a major characteristic of the second phase of a bear market. Buyers become scarce, bids falls sharply and sellers become desperate to get out. The downward acceleration becomes extreme and a near vertical drop can ensue. At first, after the March 2000 top in the Nasdaq, the decline was gradual, occurring over weeks and months although there were some sharp down weeks, especially in the beginning. But then in 2002 it got pretty brutal as the market went into free fall and very much the phase of discouragement which I'll go into next.

The decline goes on longer when there is very strong conviction about the continuation of the bull market that has ended already. The investing public, in general, does not 'believe' the potential severity of the bear market or how they will eventually react to it. The handmaiden to fear, so to speak, is hope. There is a reluctance to take a loss in stocks, especially a sizable one. Better to hope for a recovery. This is the phase where people will make a point of telling you that they are 'long-term' investors. Investors have become conditioned to stocks going up and will maintain their faith in a market rebound for longer than is warranted by facts. Hope springs eternal as is said.

3. DISCOURAGEMENT

After the initial part of the decline, which is sometimes the worst part of the decline and later when prices are not dropping so steeply, often comes the point where the economy has stabilized. Here, there can be a gradual market recovery and a rebound in prices of the stocks of the strongest companies. Or, this may be a long period where the market trends sideways. This is the third bear market phase and is marked by discouraged sellers as the market does not bounce back much, which is more typical of BULL markets. There are many that didn't sell in the panic atmosphere that had prevailed earlier but now 'give up' on stocks; this is also called the capitulation period.

Selling in the discouragement phase could also be coming from those investors and traders who bought during and after the steepest declines as they thought stocks looked cheap relative the inflated values of the late bull market stage. What causes this discouraged selling is that the rallies aren't sustained and prices sink lower. There’s an old analogy about the erosion of a bear market being like a faucet dripping. Such slow steady loss, over time, becomes buckets. Business conditions at this stage may deteriorate further. Certainly there is an absence of good news with corporate earnings as the economy slides further. Sound familiar?

The stocks that were very 'speculative', in terms of their potential to make money, may lose most of the rest of their value in this 3rd. bear market phase. There were many Nasdaq stocks that lost 80-90% of what they had gained in the prior bull market in the 2 years after the March 2000 top. Blue chip type stocks tend to decline more slowly because investors hold on to them the longest.

A bear market ends when all the possible bad news has been discounted. And after it ends there is often even more negative news that keeps coming. Keep in mind that the 'discounting' mechanism of stocks is always also an attempt to look ahead, so stock values will reflect the expectations of what earnings could be when business conditions improve; e.g., 6-8 months ahead. It also should be noted that no two bear markets are exactly alike. The 1987 bear market was amazingly short in time duration and could be measured in weeks, although the price declines were quite severe. Some bear markets skip the panic stage and others end with it as in 1987. Bear markets go on for quite different time and price durations.

The key aspect to knowing how it all works, that however steep the price swings are, such as was seen in spectacular last phase of the tech bull market run up of 1998-2000, keeping in mind the characteristics of each phase will help you keep a level head. You know what is coming when the 'excess' phase you are in ends and you can prepare for it. Keep in mind also that Dow's descriptions of these phases were made at least 110 years ago. I have added more up to date examples, but the essential nature of the market phase stems from HUMAN nature and this is the 'constant', or what doesn’t change much. This relatively unchanged human nature, ours and others, is what you have to deal with in the stock market and it can help us greatly when we can identify which market phase we are in.

TRENDS ARE OF THREE TYPES

Just as the market tends to have three phases related to mood or market sentiment, market trends can be divided into three types. The most important to investors, those who look to buy and hold stocks for as long as a stock is tending to command an increasing price over time, is the primary or major trend. The primary trend is one lasting a year or more, up to several years. There are countertrend movements to the direction of the major trend and such trends in the opposite direction, Dow called secondary price movements.

Bullish or bearish expectations for the market get overly one-sided and ahead of the fundamentals related to earnings prospects. Eventually a 'reaction' develops that causes prices to correct back to a more realistic price level. Reactions or corrections are price swings that are in the opposite direction of the main or major trend. Once these run its course, the primary trend resumes. The segments that make up the price swings that are both in, and against, the direction of the primary trend can also be referred to as intermediate price swings when they last a few weeks to a few months only.

Within these intermediate price moves are day-to-day price fluctuations that Dow called minor trends. These can be a few hours to a day or a few days; they’re most often contained within a 1-2 week period. Both intermediate and minor trends are of importance to traders primarily; minor trends are all that concern a day trader or so-called 'swing' traders who will likely complete every trade within the same day or same week. Intermediate trends are of some importance to investors when they are looking for the best point to enter the primary trend or to add to their position(s) in a stock or the market.

THE PRIMARY TREND

The primary or major trend is a price movement that typically lasts for a year or more. The exceptions to this time duration do exist and I pointed out the very short duration of the 1987 decline. One widely accepted measure of what constitutes a bear market is when there is a decline that takes prices more than 20% below the high point reached in the prior advance. Dow didn't have such a rule or guideline on this subject.

The primary trend is composed of smaller movements of an intermediate duration of a few weeks to a few months. These secondary trends run counter to AND in the same direction as the primary trend; they can also send prices into a sideways movement.

An essential guideline as to a trend being a primary bull market is that each advance within the advancing trend should reach a higher level than the rally that preceded it. And, each reaction or counter-trend move should stop at a level that is above the prior major downswing. The reverse would need to hold true to be considered a primary bear market trend.

An analogy to the primary trend is that it is like the tide of the ocean. In a rising tide, each wave comes in to a higher and higher point. And, just as the rising tide lifts all the boats, a bull market takes most or all stocks higher. The waves in an outgoing tide gradually recede away from a high point and all boats fall with it.

A primary up trend is considered to be a bull market and a primary down trend, a bear market according to Dow. If you are an investor in terms of your time horizon and investment goals, you should attempt to buy stocks as soon as possible after a bull market has begun. And example is shown in the chart below, taken from the 1990–1991 period, showing both a primary down trend or bear market and the primary up trend or bull market that developed following it:

You will notice from this period shown in the chart above that the duration of the primary bear market trends were relatively short compared to the duration of the primary uptrends. On average this has been true since the 1950s due to the longer periods of economic expansion and shorter periods of recession; there is more urgency to end a recession. Our last bear market (late 2007 to March 2009) lasted approximately 15 months.

The duration of bull and bear markets also relates to the fact that investors tend to stagger their purchases over the duration of bull markets, providing ongoing buying power, whereas selling often occurs during one or two panic selling periods, as would be buyers stay away and don't support the market in such 'waterfall' type drops.

SECONDARY TRENDS

The secondary or intermediate-term trends are of a shorter duration than the major year over year trend; e.g., 3 weeks to 3 months. Such trends interrupt the major direction of stock prices with a countertrend movement. These are the corrections in a bull market as they 'correct' the situation where prices have risen too far, too fast; these are also the recovery rallies in a bear market.

Frequently these secondary countertrends retrace anywhere from a little over a third to as much as two thirds of the prior advance or decline. Very common is to see retracements of 50% of the prior price move that was in the direction of the primary trend. It is not always easy to decide when and if a secondary trend is underway, but there are technical tools that will help, such as where an up or down trendline gets pierced or 'broken'.

To continue the ocean analogy, the secondary trend is like the waves of the ocean. They can be big and they can knock you over, but they will come in and go out within the bigger movement of the tide, the primary trend.

MINOR TRENDS

The minor trends are the price fluctuations that occur from day to day and week to week, although a minor trend will rarely last more than 2-3 weeks. In terms of the overall market trend these are just 'noise' and relatively unimportant. They can be compared to the ripples on a wave, the secondary trend. Together, the various minor trends make up the intermediate trends.

Lastly, we could say that the minor trend could be one that is set off by the actions or words of an individual; e.g., the chairman of the Fed makes a statement hinting at the direction of policy on interest rates. Or, the precipitating action might be a statement from a key company in a key industry about their actual or expected earnings or profit trends.

Last, but not least is the theory of 'confirmation' and 'divergence' discussed in my prior article on Dow theory. For this concept, came all that followed on technical INDICATORS (e.g., RSI) 'confirming' or 'diverging' from PRICE moves to new highs or lows. Also, volume is seen as confirming the price trend or diverging from it; if diverging this is warning sign for a possible reversal. Dow indicated that volume was a secondary indicator to price but he also found volume important to watch as a confirmation of the trend. If volume was falling off when a stock or the market was continuing to go up, Dow would suggest being alert for a possible reversal.

On balance, Charles Dow made a huge contribution to the understanding of market behavior or human behavior as it manifests in trading and investing in stocks and the market.


GOOD TRADING SUCCESS!