Stock prices never rise or fall in a straight line. They mostly move on a squiggly path just like waves. One of the most popular market theories—what we call the Dow theory—believes in searching for some pattern in the ever-changing mood of the market. It believes that almost every rise or fall has a similar trend. The primary trend in the market, which sets the direction of the market for a year or two, is always intercepted by a secondary trend moving in the opposite direction. The market keeps moving in one direction until and unless the primary trend itself changes direction. So the real challenge lies in spotting the trend reversal.
Johnny: Last week we had to leave our discussion halfway. Let’s carry it forward—how can we know for sure that the trend we are currently watching is the primary trend?
Jinny: The primary trend always remains a step ahead of the secondary trend. As I said, it’s like moving two steps forward and then one step backwards. The two steps are your primary trend, which will determine where the stock market would be over a period of time, say, one year. The one step backwards is your secondary trend, which marks a temporary trend reversal. The overall direction of the market is always determined by the direction of the primary trend. The Dow theory believes that individual stocks could be influenced by individual factors but the average prices of all stocks is represented by some market index following the primary trend. With one step going back but two steps moving forward you continue to move in the same direction. We can find the direction by analysing price charts. But it is not possible to predict in advance how long the primary trend would continue in the same direction. Sometimes, what seems like a temporary reversal may in fact be the harbinger of a change in direction of the primary trend. Each change needs to be analysed carefully.
Illustration: Jayachandran / Mint
Johnny: Finding a change in direction seems not so easy. What guidelines does the Dow theory prescribe?
Jinny: The Dow theory believes that once the primary trend has been identified, it will remain in effect until the market itself gives the signal that the trend has changed. The theory identifies three stages for a primary bull market trend and three stages for a primary bear market trend. The first stage of a primary bull market trend starts from the last stage of a primary bear market trend. The market is full of pessimism. At one point the market would pick up an uptrend—a reaction rally in a bear market—which in all respects just looks like any other previous secondary trend. The first signs of change in the direction of a primary trend can only be gathered by watching secondary trends. If the reaction rally that is being witnessed now fails to reach a point higher than the point reached by the previous rally, then it might be just a temporary uptrend. But if the market goes above the previous high, then you might, in fact, be watching a change in direction of the primary trend. Additional confirmation can be gathered by watching out for the future downtrend. If the future downtrend fails to take the market below the previous low, then the primary trend might have changed its direction. At this point, any new rally marks the second stage of the primary bull market trend. It is often the longest and most appropriate stage to join the market as per the Dow theory. But without much ado, the primary bull market trend moves into its third and final stage, which is marked by excess valuation and the appearance of inflationary pressure. At this stage, the market is once again preparing for a trend reversal with the primary bull market turning into a primary bear market. A temporary correction might take the market to a new low with a new rally failing to take the market above the previous high. The primary bear market trend follows the same script but in reverse order.
Johnny: It all sounds like a karmic cycle. What message does the Dow theory have for common investors?
Jinny: The first thing that you should keep in mind is that the Dow theory does not make any prescription for any short-term speculation in the stock market. The emphasis is on the primary trend which generally has a lifespan of a year or two. But you should also keep in mind that there is no formula for predicting the exact length of the primary trend, so there is always a chance of getting caught in a short-term reversal. Like any popular theory, the Dow theory has been attracting its own supporters and detractors. You would find many studies which confirm the essence of the Dow theory but at the same time you would also find people who consider it utter nonsense.
Johnny: Well, every popular formula comes along with a warning: use your own judgement.
What: The Dow theory prescribes three stages for any primary trend, either upwards or downwards.
How: Any change in direction of the primary trend can be found by comparing the primary and secondary trends together.
When: As per the Dow theory, the second stage of the primary bull market trend is the most appropriate stage for joining the market.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at firstname.lastname@example.org