STRATEGIES

Some market relationships never lose their predictive powers, writes Tom Aspray, citing timeless concepts whose impact is as evident today as it was as far back as the 1930s.

Over the long Memorial Day weekend, I rediscovered my copy of The Dow Theory, by Richard Rhea, from 1932. Now many hear the term “Dow Theory” and think only of the market timing aspects of the theory and not the other important concepts the book discusses.

In the original book, Robert Rhea analyzed some 252 editorials of Charles H. Dow and William Peter Hamilton so that he could present Dow Theory in a way that could be used by the individual investor. Rhea starts out by stating several concepts or hypotheses that he feels the reader must accept.

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A few of these, I feel, are essential to the field of technical analysis but are often forgotten or ignored by many traders and investors. It should be noted that even though I have followed the Dow Jones Averages closely for over 30 years, I have never relied solely on Dow Theory methods to generate stock market buy or sell signals. Let’s begin with some of the important concepts.

“The Averages Discount Everything:” It was Rhea’s view that the closing price of the Dow averages gave the truest reading of the current state of the economy, as well as the market participants’ view of the future economic trends.

I have found that the more one can concentrate on just the price activity, the better they will fare. Most who try to blend their fundamental view of a market or stock with technical analysis often end up on the wrong side of the market.

A good example recently was in the homebuilding stocks, as many who saw the sad state of the real estate market in their area missed one of the strongest sector moves.

Rhea then pointed out that the theory is not infallible, which should be no surprise for most seasoned investors. Unfortunately, many novice traders start out searching for the “Holy Grail” and generally do not last long.

Market trends are divided into primary movements and secondary reactions. This is one distinction that gets many into trouble and is one reason I spend quite a bit of time looking at monthly and weekly charts. Too often I have seen investors sell a stock that is just undergoing a secondary reaction in a primary bull market or buy a stock that is undergoing a secondary reaction in a primary bear market.

This can cause the most damage for short-term traders, as a market can look pretty positive from the hourly or daily charts, but quite negative based on weekly or monthly data.

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