To define Dow Theory one must be open to the concept that there are
specific rules that must be accepted without question, while at the
same time being ever aware that the theory is dynamic in its evolution.
On this page I have placed four indispensable documents related to
understanding the correct application and interpretation of Dow Theory.
Documents one and two come directly from Robert Rhea's book
The Dow
Theory, published by Barron's in 1932. The excerpts,
Evolution of a Theory and
The Dow Theory which Hamilton Interpreted
, are provided,
as written, by one of the greatest traders of his time, Robert Rhea.
Documents three and four are from today's longest running newsletter
writer, author of the Dow Theory Letters
, Richard Russell. Russell
has propounded market insights as seen through Dow Theory since 1958.
His two documents capture the proper environment under which Dow Theory
must be interpreted if the investor expects to grow account equity in
Bull periods and, as Russell often points out, limit equity draw down
during Bear periods.
As you begin your journey to understanding proper application of Dow
Theory, I wish you the best and remind you that the theory is only as
good as the individual who interprets it. There are hordes of people
who know the words of Dow Theory, with even more who give lip service
to it on CNN, CNBC, in the Wall St. Journal, and all over the Internet,
yet there are few who function from within its century old tenants.
The five men I call its Theorists have earned their titles, and you
would do well to read as much of their writings as you can. Finally,
I send you off to your research with a definition that I believe Dow
Theory, and only Dow Theory, has earned over these last 100 years. Most
of us have heard the term "Algorithm", a smart sounding computer
programming word. Actually when you delve into the meaning, the word
is as easy to understand as riding a bike. In fact, as a child, without
knowing it I'm sure, you designed your own algorithm for riding your
bike. You just never wrote it down.
Algorithms are the basis for all of the internet's search engines, they
are the drivers for all stock screening software, and believe it or not,
we have all used them since our birth. The better you design your
algorithm the better your results will be. So here I give you the
definition of Algorithm:
"An algorithm (the name is a form of al Khwarismi, a Muslim writer
whose algebra textbook was popular in the European middle ages) is
a series of steps for arriving at a result. The method of long
division as taught in school is an algorithm. First you do this,
and then based on what you did before; you do that, and so on. An
algorithm gives you the answers (if it's a correct algorithm) but
doesn't tell you why the answer is so."
As a child, you learned to ride a bike. Dad or Mom watching as you
got on and began to pedal, first with training wheels, remembering
to steer clear of obstacles. Oops, what about braking? Well, we had
better throw braking up towards the top before someone gets hurt.
After some confidence building, the training wheels came off, and now,
you needed to pedal, balance, steer, and brake. Then, before Mom could
yell at you to BE CAREFUL, you were hopping up curbs, popping wheelies,
and occasionally, skinning your knees and elbows. Without knowing it,
you were designing a mental algorithm, creating the entire bike riding
exercise. First, leg over bike, foot on pedal, push off, thrust down
on pedal with foot, second foot on pedal, thrust second foot, steer
around trash can, keep pedaling, break for cat running in front of you,
and so on. Now, in all your learning, we never discussed inertia,
thrust, momentum, etc… So, your algorithm gave you the answer that
if you do the steps; the bike will go, turn, and stop. However, the
algorithm doesn't get involved in revealing that overcoming inertia with force got you going,
while thrust and momentum kept you going.
So there it is, An Algorithm. Dow Theory works the same way. Correct
interpretation of Dow Theory will give you answers; it just won't tell
you why the answer is so. In the stock market, answers always lag the
trend changes. Markets move up before earnings improve, markets move
down before earnings falter. You'll do best if you listen to the Stock
market's algorithm for the past 100 years- Dow Theory.
