Dow Theory. Part 3

Alerts
Out of Dow and Hamilton, Ray has provided 4 separate theorems, which are aimed at determining the trend, buying and selling signals, volume, and trading ranges. The first two are the most important and used to determine the primary trend as bullish or bearish. The latter two theorems, dealing with the volume and trading range, not treated Hamilton as a means of identifying the main trend. The volume was seen as supporting statistics and trading range for determining the periods of accumulation and distribution.

Determination of trend
The first step in identifying the main trend is to identify individual trends in the Dow Jones Industrial (DJIA) and Dow Jones Transportation Index (DJTA). Hamilton used the analysis of peak and decline to set the identity of the trend. Rising trend is determined by prices, which form a series of increasing peaks and increasing recession (higher maximum and higher minimum). On the contrary, the descending trend set prices, which form a series of declining peaks and declining recessions (lower maximums and lower minimums).

Once a trend is identified, he acknowledged the current, until proven otherwise. Top-down trend is valid, yet are lower minimums, and following the restoration does not exceed previous highs. The following is a schedule Dow Jones Transportation Index in 1992. Even though Hamilton and Dow are not made specific reference to the trend line, the line was carried out to emphasize the downward trajectory of the trend. Since the peak in February, a number of lower minimums and lower peaks formed a descending trend. It was the second move in April and May (green circle), but March has not been exceeded maximum.

Transport Dow Jones continued down until the recession of the day with a lot of (red arrow). As described in Part 2 of this article, the days with large amounts of signal that the planned change effort. Day of the recession with a large volume in itself is not a signal to buy, but rather indicates the need to monitor price activity slightly closer. After that day, with a large volume index fell again and then moved above 1250, a higher minimum (green arrow). Even after the formation of a higher level, is still too early to recognize the change in trend. Changing the trend is not confirmed until the previous maximum recovery has not been exceeded (blue arrow).

In contrast, bottom-up trend is considered to be valid until the peaks are higher and the subsequent decline is higher than the previous minima. The following is a schedule of prices for the closing Dow Jones Industrial index. Ascending trend began with the minimum of October 1998. and the index for the following 11 months has formed a series of higher highs and higher recessions. Twice in December 1998. (red circle) and June 1999. (blue arrows), enhances the reliability of trend has been called into question, but the rising trend prevailed until the end of September (the movement of prices in December 1998. will be considered below).

Were lower peaks in June 1999. But has never been lower downs to confirm these lower peaks and the support stand. Those bears, who sold in June, had to wait two more historical peak in July and August. Changing trend occurred on 23 September, when the June minima have been overcome. Some traders may have decided that the trend has changed, when it was violated at least the end of August. This may indeed occur, but is worth noting that the reduction in June, representing a compelling area of support. Keep in mind that the Dow Theory is not science, and Hamilton has stressed this many times. Dow Theory is intended to provide an understanding of the principles and EY to begin a careful study of market price movements and activity.

Looking at the line graph above (DJIA 1998/1999 daily index closing at the semi-log scale), it can be difficult to distinguish real change in trend and a simple correction. For example: Is it guaranteed to change the trend, at least when the December overcame November? (red circle). After the November peak was formed by a lower maximum in December, and then the November decline was overcome. To eliminate false signals, Hamilton proposed a motion to exclude less than 3%. This is not a hard rule, but the idea is worth noting. With the increased mobility of today's markets there is a need to smooth daily fluctuations and to avoid false alarms.

Hamilton and Dow were interested in high traffic and they have tended to use weekly charts to determine the correction of maxima and minima. However, in today's markets vysokopodvizhnyh, weekly charts can not display all the details required by investors. One possible solution is to apply a short moving average price for the piece. Although not mentioned Hamilton and Dow, a 5-day moving average can be used to smooth the price series and to allow to take into account the details. The graph below (DJIA 1998/1999 index closing 5 day EMA) used 5-day exponential moving average to smooth out price segment. Note that the bottom of the November correction now seems quite irrelevant. Also, the September peak correction (red arrow) is still visible.

Average must confirm
When the Dow Theory was developed in the change of the century, railroads were vital communication links in the economy. Hamilton is often argued that the activity of transport index starts before the Industrial Index. He attributed this fact that, before to start economic activities, raw materials must be moved from suppliers to manufacturers. Before General Motors would be able to increase production, must be transported more than steel. Therefore, the increase in activity among the rail stocks presaged an increase in business for industrial shares.

Why Transportation?
There is no doubt that today's economy is very different, and the structure of transport index has changed in favor of airlines. However, there is still some reliability in the use of transport index to confirm the movement of the industrial index. Transportation stocks are much more dependent on the macroeconomic environment than the average stock and are likely to anticipate growth.
- Business aviation is a cyclical, highly sensitive and revenue to economic developments.
- Airlines generally have above-average debt levels and are more vulnerable to changes protsentnoystavki.
- Form a major part of energy costs and labor costs.

To reflect these risks, airline stocks have traditionally sold substantially below market indicators. If the attitude of the price / income for the S & P 500 is 28, the average for the airline only 8-10.
Even though we may be entering a "new economy", most businesses would be one way or another affected by changes in economic activity, interest rates, energy and labor costs. Airlines, carrying a greater burden is still likely to act as a leading indicator of overall economic environment.
However, one remark should be added. Perhaps the greatest concern for the airlines is that people will stop flying in airplanes. Business travel constitutes a large portion of airline revenues, particularly revenues from high profit. With the development of Internet and communications networks, the need for business trips in the future may be significantly reduced. "Federal Express" is already reducing the number of outgoing business correspondence. This could ultimately affect the airline industry.

As indexes confirm
Hamilton and Dow stressed that for the main trend signals the purchase or sale was valid, and industrial and transportation indexes must confirm each other. If a new index shows the new maximum or minimum, then another, for the signal to Dow theory, should soon follow him in order to be valid.
Combining the basic principles established for determining the trend with the theorem of confirmation now possible to classify the primary trend of the market. Chart above shows the set of signals that have emerged during the 7-month period and in 1998.
1. In April, industrial and transportation indexes showed new unknown peaks (blue line). The main trend was the bovine, but it reinforces the reliability of confirmation of bovine trend.
2. In July, the problems began to appear when the transport index does not confirm the new maximum set by the industrial index. This serves as a warning signal, but did not change the trend. Remember, the trend is valid until proven otherwise.
3. July 31, Transport index showed a new level. Two days later, the industrial index has shown a new minimum, and confirmed the change of trend from bearish to bovine (red line). After this signal, both indices continue to show the new minimum.
4. In October, the Industrial Index has formed a higher value in the recession, while the transport index has shown a new level. This was non-other, and serve as a warning to be alert for a possible change of trend.
5. After a high-recession, the Industrial Index later in the month showed a higher maksimum.Eto actually changed with the downward trend of the Index on rising.
6. This is not confirmed until early November, when the transport index was higher than its previous corrective maximum. However, at the same time the industrial index also moved higher, and EY trend has changed from bullish to Bear.

Volume
The importance of the amount mentioned in the 2 parts of the graph, showing the bottom for the DJIA Index in April 1997. Rey marks that, while Hamilton analyzed the statistics of the volume, price activity is the final determining factor. The volume is more important in the affirmation and strength of movements and can also help identify potential turn.

Confirmation of the amount
Hamilton thought that the volume should grow in the direction of the main trend. In most bull markets, the volume should be more on promotion than during recessions. Not only the volume should decrease with the downturn, but the involvement of the participants should also decrease. As Hamilton suggested, the market should become "despondent and narrow" for a correction, "narrow" means that the number of cuts should not be incredibly expanded. for the primary Bear Market is a true opposite. Volume should increase on the reduction and decrease during recovery. Rehabilitation motion must also be narrow and reflect the low involvement of a broader market. Analyzing the recovery and correction, it is possible to estimate the force of the main trend.

Size and Facing
Hamilton noted that the high volume levels can be indicators of an impending turn. After a day sbolshim volume, long promotion may signal that the trend is going to change soon, or could be formed rehabilitative peak. In his comments on 25 June 1999. at StockCharts.com, Rex Takazugi discusses the correlation between the peaks and the market. Even though his analysis shows the time delay between the peaks of the volume and the market turns, the link is still there. Takazugi analysis shows that with the 1900g. was 14 cycles, and the volume reaches a maximum at an average of 5.6 months ahead of the market. He also drew attention that the latest volume of the peak was reached in April 1999.

Trading ranges
In his comments, Hamilton many times over the years turned to "lines." "Lines" are called horizontal lines that form trading ranges. Trading ranges are formed when the indexes are in the lateral movement during a period of time and allow for a horizontal line connecting the tops and bases. These trading ranges indicate, or the accumulation or distribution, but in fact it is impossible to say when a breakthrough top or bottom side. If the breakthrough was the top hand, the trading range would be considered savings. If there was a breakthrough bottom side, the trading range would be considered distribution. Hamilton considered neutral trading range, until a breakthrough occurred. He also warned against trying to anticipate a breakthrough.

Application of Dow Theory
Mark Halbert of the New York Times September 6, 1998. noted a study that was published in the Finance magazine Stephen Brown of New York University and William Gotsmanom and Alok Kumar of Yale University. They developed a neural network, which includes the right to determine the main trend. Dow theory system was compared with the strategy of "buy - and - hold" for the period from 1929g. to September 1998. When the system determines the main trend as bullish, in a hypothetical index fund open long positions. When the system is reported to bear the main trend, the shares were sold and the money placed in instruments with fixed income. When withdrawal of money from the stock after the bear signal, portfolio volatility risk is greatly diminished. This is a very important aspect of Dow theory and portfolio management. Over the past few years, the concept of risk in the shares fell, but the fact that equities have a higher risk than bonds remains.
During the 70-year period, Dow theory system was profitable strategy "to buy - and - hold" for about 2% per year. In addition, the portfolio carried significantly less risk. If we compare this figure as income in relation to risk, the superiority of the system would increase even more. Over the past 18 years, the Dow theory was less efficient by about 2.6% per year. However, if you calculate the income relative to risk, the system theory of Dow for the past 18 years proved to be an effective strategy to buy - and - hold. " Keep in mind that 18 years is not a long period in the history of the market. Dow theory system was less effective in the bull market and a more favorable during the Bear market.

Criticism of Dow Theory
First, criticism of Dow theory is that it really is not a theory. Neither Doe nor Hamilton would have written the relevant academic papers, highlighting the theory and test the theorem. The ideas put forward by Dow and Hamilton through their articles in the "Wall StreetJournal". Robert Rey connects with the theory, detailed examination of these articles.
Secondly, the Dow theory is criticized for too late signals. The trend does not change with the Bear on bullish until the previous maximum recovery would not be overcome. Many traders feel that this is simply too late and miss most of the movement. Dow and Hamilton tried to catch the heart of the movement and join the second wave. Even if it is the position where the majority of movement occurs, it will still be missing the first wave and part of the second wave. And if you want to wait for confirmation from other indices, it will be even later.
And third, because the indexes used and the DJIA DJTA, Dow theory is criticized as outdated and no longer accurately reflects the economy. It may be fair comment, but as mentioned above, the index DJTA is one of the most economically sensitive indices. Stock Exchange is seen as a barometer of economic growth. To at least keep the industrial action at a level to the index were added to "Home Depot", "Intel", "Microsoft" and "SBC Corp", replacing the 1 November 1999. "Chevron", "Goodyear", "Sears and Union Carbide".

Conclusion
The purpose of Dow and Hamilton was to determine the primary trend and catch the big traffic. They knew that the market is influenced by emotions and tend to over-correction as an up and down. Remembering this, they have focused on identifying and following: Identify the trend and then follow him. The trend is valid until the contrary is proved. Trend ends when it is proven.
Dow Theory helps investors identify facts and not make assumptions or predictions. It can be dangerous, when investors and traders are beginning to assume. Predicting the market is difficult if not impossible to play. Hamilton readily admitted that the Dow Theory is not faultless. At the same time, Dow Theory can help form the basis for analysis and is the starting point for investors and traders to develop the basic principles of analysis that will be comfortable and familiar to them.
Reading the market is an empirical science. Where would also meet exceptions to the theorem, put forward by Hamilton and Dow. They believed that success in the markets required serious study and analysis that has successes and failures. Success - a great thing, but should not be too smug. Failures, when they are sick, should be considered as a practice. Technical analysis is the art and the eye becomes more acute with the practice. Study the successes and failures in the future.

Arthur Hill
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