The "Hypotheses" of the Dow Theory

In his book, The Dow Theory, Rhea listed what he called the "hypotheses" and "theorems" of Dow Theory. Actually, they should be termed principles and definitions, because Dow Theory isn't a strict system like mathematics or the physical sciences. That aside, since so many interpretations of Dow Theory are wrong. I'm going to go right to the source. I'll present Rhea's observations in the order he gave them and in his own words.2 For the most part, these ideas stand firm today but warrant some clarification and minor revision, which follows after each quote.

According to Rhea, Dow Theory rests on three basic hypothesis that must be accepted "without any reservation whatsoever."

Hypothesis number 1:

Manipulation: Manipulation is possible in the day to day movement of the averages. and secondary reactions are subject to such an influence to a more limited degree, but the primary trend can never be manipulated.

The essence of this observation is that the stock market is too diverse and too complex for one person or group to affect prices in the market as a whole for a sustained period of time. It is a crucial tenet of Dow Theory because if the movement of market prices as a whole could be artfully changed according to the will of one person, looking at an average index would lose any meaning beyond deciphering what the manipulator was up to. The critical importance of Hypothesis 1 will become even more evident when we examine Hypothesis 2.

Dow, Hamilton, and Rhea all thought that the degree of manipulation in their time, both by individuals and through pools, was highly overestimated. They all thought that cries of manipulation were, predominantly, desperate attempts by individuals who made mistakes in speculation to explain away their errors without claiming self-responsibility.

I believe the same is true today. In the context of our modern, highly regulated markets, manipulation by individuals is practically impossible, even in the short term. Program trading, however, can be an important form of manipulation, as will be described in Chapter 6. It is still true that the primary trend cannot be manipulated in a fundamental, long-term sense, but the character of the trend can be changed, as we learned during and since the crash in October, 1987. Institutional trading, because of the billions of dollars involved, can accelerate the primary trend in either direction.

Hypothesis number 2:

The Averages Discount Everything: The fluctuations of the daily closing prices of the Dow-Jones rail and industrial averages afford a composite index of all hopes, disappointments, and knowledge of everyone who knows anything of financial matters. and for that reason the effects of coming events (excluding acts of God) are always properly anticipated in their movement. The averages quickly appraise such calamities as fires and earthquakes.

[Note: To Rhea's parenthetical observation "(excluding acts of God)," should be added "and excluding acts of government, especially acts of the Federal Reserve Board."]

In Charles Dow's terms, the same basic idea was stated as follows:

The market is not like a balloon plunging hither and thither in the wind. As a whole, it represents a serious, well-considered effort on the part of farsighted and well-informed men to adjust prices to such values as exist or which are expected to exist in the not too remote future .

The major refinement necessary to bring these observations up to date is that they apply not just to the Dow Jones Industrial and Transportation averages, but to all well-formulated market indices, including bond, currency, commodity, and options indices.

There is nothing mystical about either the discounting effect or the business forecasting value reflected in the market averages. Investors (those who hold securities and other instruments long-term) use the stock and other market exchanges to allocate their capital toward companies, commodities, or other financial instruments which they think are most likely to be profitable. They place their economic resources according to their evaluations of past performance, future prospects, individual preferences, and future expectations. Ultimately, the companies and investors who best anticipate the future demand of consumers (consumers in the broadest sense, including those in the capital, wholesale, and retail markets) survive and are the most profitable. Correct investments are rewarded with profits, and incorrect investments suffer losses.

The result of the actions of speculators and investors through the financial markets is a tendency to expand profitable ventures and restrict the unprofitable. Their actions can do nothing about the past and cannot solve the problem of the limited convertibility of capital goods already in existence, but they generally do stop good money from being thrown after bad. The movement of the market averages is simply a manifestation of this process.

If, on average, market participants failed to correctly anticipate future business activity, we would experience a continuing decline in wealth, and there would be no such thing as a sustained bull market. The fact that, on average, stock traders do properly predict the future of business activity causes the cycle of stock price movements to lead changes in the business cycle. The time lag results from the fact that stock transactions are liquid, whereas business adjustments, because of the limited convertibility of inventories and capital goods, are not.

When Rhea stated "the effects of coming events (excluding acts of God) are always properly anticipated" (emphasis added), he really meant it. But implicit in his statement is a recognition that "properly" discounting includes a divergence of opinion on the effects that present events will have on future business activity. The market averages represent optimists, pessimists, and "realists"-a full spectrum of individuals and institutions with specialized knowledge that no one person can duplicate.

Rhea didn't intend to imply that market participants are always predominantly right in their interpretation of coming events, but he did mean to imply that the averages always reflect the predominance of opinion. To the practiced observer, the averages will indicate the direction and strength of the long-term trend. they will show when the markets are overbought or oversold, they will tell when the tide of opinion is changing and when the risk of involvement in the markets is too great to participate in any significant way.

I added the note "excluding acts of government" to Rhea's hypothesis because government legislation, monetary and fiscal policy, and trade policy, like natural disasters, can have an immediate and dramatic impact on market price movements because they have enormous long-term economic impact. And because government policy makers are human beings, it is impossible to always correctly anticipate what they will do. An excellent example of this occurred on July 24, 1984, when Fed Chairman Paul Volcker announced that the Fed's restrictive policy was "inappropriate." In anticipation of easier credit policies, the stock market averages made their low that day, and the new bull market began.

Hypothesis number 3:

The Theory Is Not Infallible: The Dow Theory is not an infallible system for beating the market. Its successful use as an aid in speculation requires serious study, and the summing up of evidence must be impartial. The wish must never be allowed to father the thought.

The stock market is a collection of individual human beings, and human beings are fallible. With almost every stock trade, one person is right and another is wrong. While the averages do in fact represent the net effect, or "collective wisdom" of market participants' judgements about the future, history shows time and again that millions of people can be as wrong as one, and the stock market is no exception. The nature of the market simply allows participants to adjust and correct their errors rapidly. Any method of analysis that claims the markets are infallible is flawed at its roots.

The theory of "efficient markets" is a case in point. The main premise is that with the advent of computers, information is disseminated so fast and efficiently that it is impossible to "beat the market." This is nothing more than an extrapolation into absurdity of Dow Theory's tenet that "the averages discount everything." It is also ridiculous. The idea that everyone receives all significant information simultaneously is absurd because everyone doesn't agree on what is "significant." Even if everyone did receive exactly the same information simultaneously, they would respond to it according to their own particular circumstances and preferences. If everyone knew exactly the same things and responded the same way, then there would be no market! You must always remember that markets exist to facilitate exchange, and exchange is the result of differences in value preferences and differences in judgments .

The predictive value of the market indices lies in the fact that they are statistically representative of a consensus of opinion expressed with money invested in the markets. Ultimately, it is people's judgements and preferences that determine prices. If you ask floor traders what is behind a price rise in their market, many will half-jokingly respond, "More buying than selling." What that answer really means is, "I don't know the reasons, but the predominance of opinion, as expressed by money changing hands on the exchange floor, is that prices are going up."

The primary task of the speculator is to identify the major active factors which drive or will change the predominant trend of market participants' opinions, and the market indices provide the best tool with which to correlate events with public opinion on financial matters. The events considered can include everything from political and economic developments, to technological innovations, to fashion trends, to the earnings prospects of a particular company. Since this can only be done in the context of history, the best you can do is identify the predominant factors of the past and project them on to the future. Some factors remain constant throughout history; and in general, the fundamentals which guide opinion change slowly over time. With effort, you can abstract those fundamentals and forecast the future with a high probability of accuracy.

In Hamilton's terms, the averages are a barometer for economic forecasting. In weather forecasting, the barometer is a tool for measuring changes in atmospheric pressure. Since changing atmospheric pressure always precedes changes in weather conditions, the barometer is an invaluable tool in predicting weather changes. But the barometer in itself tells the forecaster nothing about the type or quantity of precipitation to expect, nor will it accurately correlate to exact temperature changes. Similarly, the market averages are an essential tool in economic forecasting. but a great deal of supplemental information is required to piece together the entire puzzle.

From: Victor Sperandeo's Trader Vic: Methods of a Wall Street Master.