Catch The Dow and
|Dow Theory hasn't missed a beat in over 100 years. So what does
the mind of Charlie Dow have to offer modern traders?
||One of Dow's powerful concepts is the three-waves principle.
Decades after Dow first wrote on the subject, R.N. Elliott took
up the cause to create his unique Elliot Wave Theory. So let's
combine their work, and see what these guys taught us a few
dozen years before we discovered the markets were a good place
to hang out.
|Dow's three waves were built on the concept of the primary
trend. We all know what Charlie was talking about here. The
primary trend is the major market direction over years or
decades. This is how we determine whether we're in a bull market
or a bear market. Dow determined this primary trend by looking
at long-term price patterns and seeing the obvious.
Elliott used his five-wave trend to reach the same conclusions.
He noted that the primary trend was composed of three waves
moving in the major direction and two waves moving against it.
Furthermore, each primary wave hid a smaller wave structure that
exposed the true nature of price direction. For example, Elliott
commented that failures exhibited a rollover of certain waves
within this fractal structure and gave rise to trend reversals.
In Dow's world, a market printing higher highs and higher lows
revealed a primary bull trend. Conversely, a market printing
lower highs and lower lows revealed a primary bear trend.
Elliott had no problem with this view, but he added a few twists
of his own. For example, he pointed out how certain phases of a
primary trend showed very limited counter-waves and rarely
pulled back until the entire wave set was completed.
Three-wave principles get more interesting when Dow and
Elliott describe characteristic crowd behavior in each of the
waves. Let's examine these through a bull market cycle.
The first wave triggers value buying by patient investors who
anticipate better economic conditions and long-term growth. This
occurs during the same period that sentiment records its lowest
readings and experts tell everyone in sight to stay away from
the financial markets. Value investors wake up from this gloom
and realize that the fear-filled talk hides a nascent recovery.
They buy aggressively from distressed sellers and nurture a
Elliott noted that this first wave shows very gradual price
improvement and turns back on itself frequently to test lower
levels. He also points out that this wave takes a long time to
complete and gives a true bottoming appearance to the chart. The
good news is that the market eventually triggers enough momentum
to carry price up to much higher levels.
Bullish evidence begins to mount in Dow's second wave.
Improved corporate earnings, increased employment and unexpected
innovation characterize this midpoint of a broad bull move. Less
demanding investors now enter the market because they see better
times ahead and want to participate. They build good-sized
portfolios and start to follow the markets with great interest.
Elliott sees this wave as the most dependable phase of the
entire bull cycle. Price movement advances rapidly, with less
overlap from day to day. Small gaps appear between bars as
investors buy high and look to sell higher. A sharp advance
often triggers right in the middle of the wave, when a burst of
enthusiasm forces a wide continuation gap. This powerful move
often marks the exact middle for the entire three-wave event.
Danger signs grow during Dow's third wave, but they're hard
to accept because of an outstanding market environment. Record
earnings and full employment lead the media to proclaim an era
in which the sky's the limit. Joe Sixpack now joins the hunt as
the public forgets about its losses from the last bear cycle.
This broad market participation starts a buying panic. At this
very moment, the smart-money investors who bought at the bottom
begin to unload their positions into the hands of the waiting
public. The market eventually runs out of gas and prints a
The last wave in Elliott's world can show a parabolic spike, or
a failure move before it gets under way. This dichotomy points
out the danger the public faces when it enters the stock market
in force. Elliott noted that the large-scale reversal off this
last wave may be very deep and painful. As we now know from
personal experience, this rapid selloff addresses the many sins
common to all bull cycles.