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The number one investment skill

This article appeared in the April 2013 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.

Knowing how bull and bear markets unfold, using Dow Theory analysis, makes a huge difference to returns.

Photo of Dale Gillham By Dale Gillham, Wealth Within

Ask any investor or trader if they know how to buy a share and chances are 100 per cent will say yes. Ask if they know the right time to sell and 90 per cent will say no, or that they get it wrong on most occasions.

Although knowing when to exit is, or should be, part of everyone's risk strategy, the problem of getting out of a stock occurs because of something far more fundamental: it seems so few really understand how to determine the direction of a market or stock. The lack of knowledge and understanding in this area among traders is so bad it is like a black plague killing would-be traders in its wake.

I believe the number one skill all successful investors/traders should possess is accurately identifying direction.

If you can correctly ascertain the direction of the longer-term trend, bull or bear, you can pinpoint with great certainty the right time to buy and sell, meaning far more profit.

A pattern of bull and bear markets

What do bull and bear markets look like, how do they unfold and how do you recognise the start and end of one?

Unfortunately, many investors either ignore or do not understand this crucial element to successful investing, and I really cannot blame individual traders or investors for this lack of understanding.

The financial industry has for years advocated the motto that "time in the market' is most important when it comes to investing, rather than looking to time the market for the most suitable position to buy and sell. Accepting that "time in the market" is more important than "timing the market" leads to poor returns.

Since the GFC, everyday investors have become more aware that the old "buy and hold" methodology is flawed. Taking control of their own investments rather than handing their savings over to big funds is a step in the right direction to outpace standard market returns and secure a far better financial future. The desire for better returns can be seen in the explosive growth of self-managed super funds (SMSFs) over the past several years.

Markets will always rise and fall, but the basic tenets of making superior gains remain the same.

A perfect example is famed investor Warren Buffett. His reliance on "value investing" methodology remains unwaivered even though the markets have moved from boom to bust over the decades that he has headed Berkshire Hathaway. His steadfast investing principles of buying great companies for a steal has allowed him to become one of the world's richest men. Contrary to what you may think, he too times his entry into investments.

Despite what the industry may advise, it really is quite easy for an individual trader or investor to make superior returns from the market if they know the market's direction. They just need to understand some simple rules that have been used for well over 100 years, and they can accurately gauge the start of a bull run and/or avoid a bear market.

A master of the markets

Charles Dow, who established the Dow Jones Industrial Average in 1896, was arguably one of the first analysts to truly define the commonalities found in bull and bear markets. He discovered that certain measurable trends evolved over time. Unfortunately, he died before he was able to quantify and publish his full findings.

However, a number of Dow's associates combined his various workings into what we know today as Dow Theory. I believe this theory is so powerful when understood properly that I have devoted a large section of my Diploma of Share Trading and Investment course to it, and more importantly I use it every day in my trading life.

In this article I look at what I believe to be the most crucial Dow findings and how you can use them to your advantage in determining market direction.

The two primary tenets of Dow Theory relate to trend.

  1. There are three types of trends in the market:
    • A primary trend, either bull or bear, which may take place over several years.
    • Secondary movements or reactions, which usually take place over many weeks or months and run contrary to the primary trend.
    • Daily fluctuations, which can move in either direction (bull or bear).

    Figure 1 below indicates the three different types of movements in the market

    Figure 1 image indicates the three different types of movements in the market 
    Source: Wealth Within

  2. Each primary trend is divided into three phases

The primary movements, either bull or bear, as shown in Figure 1, are the principal focus of Dow Theory. Primary trends unfold in a similar pattern each time, and encompass three phases.

The three phases of a bull market include:

  • Phase 1: Renewing confidence
  • Phase 2: Improved earnings
  • Phase 3: Rampant speculation.

The three phases of a bear market include:

  • Phase 1: Abandonment of hope
  • Phase 2: Decreased earnings
  • Phase 3: Distressed selling.

Figure 2 below highlights the three phases of a primary trend in both a bull and bear market

Figure 2 image highlights the three phases of a primary trend in both a bull and bear market

Source: Wealth Within

Although the above diagram is a high-level simplistic view of Dow Theory, understanding this concept really is invaluable to anyone in the sharemarket. For those new to this concept, I suggest you look at monthly bar charts showing the complete history of the stock so as to determine which phase it is in.

Applying Dow Theory to our market

Below is a weekly chart of the All Ordinaries Index at March 15, 2013. I have marked several areas with the relative phases the market appears to have completed and the current phase that looks to resemble "Improved Earnings".

Weekly chart of the All Ordinaries Index at March 15, 2013 showing relative phases the market appears to have completed and the current phase that looks to resemble Improved Earnings

Source: Wealth Within

We will look at each section in more detail.

The GFC and subsequent major low into March 2009 was the end of a primary bear market. As Dow observed, the final phase of the primary bear market is distressed selling, and all those that had not yet sold would have given up hope of a return to higher prices and started to exit positions.

Around this time, smart investors would have been preparing to re-enter the market. But how would they know the right time?

Part of Dow's research involved determining the patterns that signalled the end of one primary trend and the start of another. In the case of the start of a new upward trend, Dow observed:

"A new upward trend will be confirmed when the market doesn't move to a consecutively lower low and high."

In other words, a new upward trend, Dow Theory suggests, is confirmed by higher lows and higher highs. It is the understanding of this simple insight that separates successful investors and traders from the not so successful. Implementing this simple technique for trend transition will put you in a far better position to profit from a trade and improve your results dramatically.

In the chart above I have marked the first instance where a higher low was confirmed (first purple box) following the 2009 low, suggesting the market was returning to an upward trend. This could also be considered the start of the first phase in a new primary bull market - increased confidence.

Here is a hint: The opposite of what I have shared above is correct in recognising the start of a bear market.

A secondary reaction into the 2011 low (Point B, second purple box) followed the peak of the first phase in April the same year. Notice how this low took out the previous significant low at Point A. Some may have taken this to be a return to a primary bear market, given the energy of the pullback.

Yet the accumulation into Point C (notice again the consistent higher lows and highs during this smaller run) suggested that a return to higher prices was likely. Smart investors would have seen this and began buying top-quality companies.

As we can now see, the market has traded significantly higher over the past several weeks, breaking the April 2011 high and travelling in what appears to be Phase 2 of the primary bull market - "Improved Earnings". This implies that we should see a third phase in the bull market before moving into the next bear market.

A word of caution: we have used weekly charts in this example and as such the analysis reflects the possible short to medium term view being the next six to 18 months.

You can see that by simply being able to recognise the direction of the market, by understanding century-old, tried and tested methodologies for market phases, you can become the profitable trader you want to be.

About the author

Dale Gillham is author of 'How to Beat the Managed Funds by 20%', and is Director/Chief Analyst of Wealth Within.

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