Bull versus bears: What Dow Theory tells us

Photo of Robert Brain, ATAA By Robert Brain, ATAA

min read

Where the sharemarket is now and what may bring a change.

According to Dow Theory, there are reputed to be three stages to a bull market, so which one are we currently in and what might happen next?

Many people have heard of Dow Theory but are often puzzled by it. In this article, I explain some key aspects in relation to bull markets, possibly challenging your thinking about investing.

Dow Theory refers to a body of knowledge that underpins key aspects of contemporary technical analysis. It does not guarantee total success in the markets but is useful because the price charts of financial instruments summarise the opinions of the market participants.

Knowing something about the basics of Dow Theory will help with understanding the underlying mood and sentiment of the participants, to help give you an edge.

There are six key tenets of Dow Theory and here we will focus on only some of them.

Tenet No. 4 — “A trend remains in effect until a clear reversal”

To help set some foundation understanding, let’s skip the first three tenets of Dow Theory and talk briefly about share price trends — uptrends and downtrends.

In technical analysis terms, a trend is defined on the price chart as a sequence of higher peaks and higher troughs for a bull market period (an uptrend), and a sequence of lower peaks and lower troughs for a bear market period (a downtrend).

In the first chart (a weekly chart of the All Ords index), note the sequence of higher peaks (labelled P1, P2, P3, etc.) and higher troughs (labelled T1, T2, T3, etc.). They indicate an uptrend from 2003 until 2007.

Trends — the basics

© February 2017, Robert Brain

Larger chart and more details: Brainy's Share Market Toolbox

Note there are many more peaks and troughs on this chart, situated between the labelled ones. These indicate the shorter-term noise and can also be used to indicate a price trend in shorter time periods. The important point is that over the period 2003 to 2007 the index was in an uptrend.

The Dow Theory tenet, “a trend remains in effect until a clear reversal”, suggests that once an uptrend is in place, it is considered to be in place until we no longer have a higher peak and a higher trough (and conversely for a downtrend).

When identifying these on the price chart, we sometimes have to ignore the noise of the intermediate swings (peaks and troughs) within the bigger-picture trend. This is the challenge of identifying the different trends in the different time periods.

As it happens, once a trend is in place and confirmed, it is likely to continue until it is confirmed to have finished.

Tenet No.2 — “The market has three main movements”

The first of the three main movements to which this refers relates to the longer-term bull or bear markets, which can last from about one year up to several years.

In the first price chart above we can clearly see a bull market in the first three quarters of the chart, which lasted for about five years, and a bear market in the last quarter of the chart, which lasted for about 16 months. So, a bull market and a bear market are the first of the three different types of main movements. They can also be referred to as a primary movement, or primary uptrend (or downtrend).

The second of the three main movements is the medium-term move where the price retraces (also called a secondary reaction). It can last from about 10 days up to several months, and we can see many of those in the chart — both downward moves within the bull market, and upward moves within the bear market.

The third main movement is a reference to the very short-term noise and can last from just a few hours to many days. The average retail investor should not focus too much on the market noise while the short-term traders take advantage of these market swings back and forth in these short time periods.

Tenet No. 3 — “Primary movements have three phases”

Now that we have looked at our market in recent years, and identified some primary market movements (especially the uptrends), we can consider this next tenet of Dow Theory. The three phases within the primary movements are: (a) accumulation phase, (b) public participation phase and (c) excess phase.

It is a little difficult to spot these three phases for many of the primary uptrends considered above — unless we also look at the volume (share turnover).

So, the next chart shows the last two-year period from February 2015 until 17th February 2017. It is a weekly chart again, but also shows the weekly volume in the bottom pane.

Trends are confirmed with volume

© February 2017, Robert Brain

Larger chart and more details: Brainy's Share Market Toolbox

In this chart, note what happened the last time a bull market uptrend ended, in April 2015 (the left end of this chart, before falling 19 per cent from P17 to T19).

The index tried to move higher but could not push above about 5960. For several consecutive weeks in March and April the volumes decreased week on week (indicated in this chart).

These declining volumes indicated less and less interest in purchasing stocks (that is, declining demand) and eventually resulted in the index commencing a fall in late April. This is what happens when the demand dries up, leaving a lot more willing sellers compared to the dwindling number of buyers.

This is the sixth tenet of Dow Theory — “volume provides additional evidence”.

That is some of the theory, now let’s look at the practical aspects.

Which bull market stage are we in?

Let’s start by looking at the quarterly chart of the index below. We can easily spot the bear market bottom in March 2009 (T12). This is followed by what might initially look like a good sequence of higher peaks and troughs — except that, technically, it is not.

The latest bull market (XAO — Quarterly chart)

© February 2017, Robert Brain

Larger chart and more details: Brainy's Share Market Toolbox

There are several periods on this chart that are primary (bull market) uptrends. Each of these have secondary reactions between them. What is likely to unfold in the coming weeks?

If we drill down and look at the weekly or daily chart for the same period, any conclusions should be clearer. Consider the following daily chart:


The latest bull market (XAO — Daily chart)

© February 2017, Robert Brain

Larger chart and more details: Brainy's Share Market Toolbox

First, note that daily volumes increased through January and into February 2017 while the index fell by only 3 per cent. This indicates an excess of sellers.

For the current bull market uptrend to be confirmed we need to see the index push higher than the earlier peak P17 (a potential resistance level off the left edge of this chart).

Perhaps the end of the February reporting season will help investors weigh up whether this is likely. And if it does happen, we ought to see the index continue to “trend” higher (higher peaks and troughs), and with increasing volume to indicate the increasing interest in participating in the market.

If the volumes decline while the index rises, it will indicate a lack of interest and a lack of support for the higher prices, and forewarn of a possible fall.

Depending on the final outcomes of the half-year reporting season, we might see enough positive results and earnings forecasts to encourage investors to rush into the market.

If this happens, we might see irrational exuberance — a sign of the final “excess” phase of a bull market. And if Wall Street starts to think that Donald Trump will not be as successful as everyone had thought in stoking the US economy, then we could see the bull market here in Australia, and in the US, come to an end.

So, keep an eye out for higher peaks and troughs, and for increasing volume on the upward legs.

About the author

Robert Brain is a sharemarket analyst and Nimble Short Term Investor, and runs Brainy's Share Market Toolbox web-based business, supporting investors and traders. He is a national director of the Australian Technical Analysts Association (ATAA) and vice-president of the Melbourne ATAA Chapter. The price charts shown are produced using the Australian BullCharts software.

About the Australian Technical Analysts Association (ATAA)
ATAA is the knowledge network for successful financial market trading and investing. It is a not-for-profit association of people interested in the application of technical analysis. Many members operate their own SMSF, some are private traders/investors and some are professionals in the financial services industry. The ATAA has nine Chapters around Australia, in capital cities and provincial centres. For more details: www.ataa.com.au.

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