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July 09, 2006

Dow Theory
by Tim Wood

Most everyone who has even heard about Dow theory understands the elementary principle of confirmation and non-confirmation between the Industrials and the Transports. There are many other principles of Dow theory that few understand. Among these principles are the concept of Primary movement verses Secondary movement, bull and bear market phasing buying and selling spots verses confirmation of buy and sell spots, and value to name a few.

Something else that I noticed from my study of Dow theory was the historical relationship between previous bull and bear markets. When studying about the bull and bear markets of the late 1800's and very early 1900's, I realized that the bull and bear markets that the early Dow theorists wrote about were much shorter in duration than they are today. Now understand that cycles are not apart of Dow theory, but when I looked at the early bull and bear market periods as defined by our Dow theory fathers, I realized that these bull and bear market periods consisted of a single 4-year cycle. The bull market was one and the same with the upside of the 4-year cycle and the bear market was one and the same as the downside piece of the 4-year cycle.

Then, as our country grew, more and more people entered the markets. As a result, the bull and bear market periods, as defined by Dow theory, evolved and also grew in duration. The first such great bull market was born out of the 1921 bear market low. From that low the first extended or great bull market advance began. This advance lasted 8 years and carried the market up into the infamous 1929 top. From a cyclical perspective this advance carried the market up for two full 4-year cycles, which was also a first and corresponded perfectly with the Dow theory movement. This first great bull market period carried the DJIA up in that "Primary" advance, a total of 568%.

The next great bull market began in 1942 and topped in 1966. This time the "Primary" bull market was extended even further in time lasting some 24 years. From a cyclical perspective this advance ran for six consecutive 4-year cycles. As a result, the magnitude of the advance also grew. This time around, the second great bull market pulled the Industrials up 1,076%.

The last and Greatest Bull market of all time began with the 1974 Phase III and bear market low. This time, the "Primary" bull market advanced an unprecedented 26 years topping in January 2000. This mammoth advance carried the Industrials up some 2,061% and cyclically consisted of seven consecutive 4-year cycles.

Beside the growth aspect of these great bull market periods, there is another important point. Note that the first advance was 568% with the second one being 1,076%. The point here is that the second advance doubled the magnitude of the first. But, also note that with the last great bull market period being 2,061%, its magnitude was double that of the second great bull market. Yes, each of these great bull market periods have grown in duration and doubled the magnitude of the previous advance.

But, when reading about the bull and bear market periods of the past, another relationship became obvious. That being, the duration of the bear market in relationship to the preceding bull market. I found that the early bear market periods, as defined by these great Dow theorists, were roughly one-third the duration of the preceding bull market. But what about the Great bull and bear market periods?

Let's take a look. The 1921 to 1929 bull market was 8 years in duration with the bear market that followed running 3 years from 1929 to 1932. Therefore, the bear market duration was 37.5% of the preceding bull market. Cyclically, this bear market period consisted of one shortened 4-year cycle. The 1942 to 1966 bull market was a 24 year affair with the 1966 to 1974 bear market running 8 years in duration or two 4-year cycles. So, this bear market lasted 33.3% of the duration of the preceding bull market. As stated above, the last great bull market ran from the 1974 low into the 2000 top for a duration of approximately 26 years. So, 33.3% of the previous 26-year Bull market would mean that this bear market would last some 8 ½ years, which would take the market down into 2008. 37.5% of the duration of this last great bull market would mean that it would last approximately 10 years into 2010. One thing is for sure, the bear market will end with a 4-year cycle low and the phasing of that cycle does not suggest a low in 2008. However, the 2010 window is looking like a very good candidate. So, in spite of the fact that the bull market periods have grown in duration, the bull/bear market relationships have held constant. Therefore, from a historical perspective of true Dow theory bull and bear market relationships, the 2002 low was NOT the bear market low.

Yes, I know that many may be saying that this time is different and perhaps it is. We know that the liquidity infusion is obviously a factor that will have some effect. Perhaps it will only serves to further extend the bear market or perhaps it lessens the decline into the low. But, perhaps it only makes matters worse in the end. Whatever the outcome will be is obviously unknown at this time, but to bet against these relationships may not be wise.

Another very very important and often over looked aspect of the Dow theory that very few understand is the phasing of bull and bear markets. The great Dow theorist E. George Schaefer stated: "There are three principle phases of a bear market: the first represents the abandonment of the hopes upon which stocks were purchased at inflated prices; the second reflects selling due to decreased business and earnings, and the third is caused by distressed selling of sound securities, regardless of their value, by those who must find a cash market for at least a portion of their assets." These words are merely a guideline and here too the application of this concept is where the art and the science meet.

The great Dow theorist of the 1930's, Robert Rhea, described the three phases of the bear market in a very similar way. More importantly, Rhea goes on and states: Each of theses phases seems to be divided by a secondary reaction which is often erroneously assumed to be the beginning of a bull market." Does this sound familiar or what? Rhea also states: " Such secondary movements seldom prove perplexing to those who understand the Dow theory."

I have spoken many times in the past about Dow theory phasing. Today I want to address this topic again and perhaps an example would be helpful to illustrate this concept. Since the Dow theory currently tells us that we are still operating within a Primary bear market, I will use the more recent 1966 to 1974 bear market to illustrate this point. I specifically want to compare the three phases of the 1966 to 1974 great bear market to what appears to be occurring today.

Phase I of the second great bear market began at the previous bull market Phase III top in February 1966. This top was confirmed under Dow theory in May 1966. From this top the market declined into the Phase I low in October 1966. This Phase I decline is marked in blue on the chart above and it carried the Industrials down some 25%. From this Phase I low the typical rally that serves to separate Phase I from Phase II began. This rally carried the market up some 32% from its lows over a 26 month period and is marked in green on the chart above. During this 26 month advance you can see that there were a couple of false breakdowns that the market was able to recover from and inevitably pushed higher.

I can assure you the Dow theorists of that day understood that this advance was the rally separating Phase I from Phase II. I know because I have documentation from that time. I also suspect that this rally lasted longer than they expected and again, I attribute that to the fact that these bull and bear market periods continue to grow in duration. However, those who truly understood the Dow theory are on record for knowing what was going on and the longer the market held up the more bullish the general public became in spite of these warnings. After the recovery from the second false break I'm sure that the public was convinced that a new bull market was underway. Many proclaimed that anyone stating anything other than this "obvious" bull market that was underway had to be in error and that the Dow theory had finally been proven wrong.

However, in spite of the false breaks, the bullish sentiment, false recoveries and claims of new bull markets, the Dow theory prevailed and the decline into the Phase II low carried the market down some 36% over a 17 month period. This Phase II decline is marked in yellow on the chart above.

Then, came the rally separating Phase II from Phase III of this ongoing secular bear market. This rally carried the market up 66% over a 32 month period. This advance is also marked in green on the chart above. Once again, the world was convinced that the bear market was over. After all, the market had made a new high. How in the world could we still be in a bear market with the market at new highs? Those crazy Dow theorists had to be wrong this time around.

But, once again, the Dow theory phasing prevailed and the Phase III decline took the market down 45% into the final low of the second great bear market. This time, those who understood the Dow theory began looking for the bottom. In fact, Richard Russell actually issued a special report in December 1974 stating that conditions were right for the bear market bottom. In this special report he actually talked about the phasing and value as part of his reasoning.

This brings us to our current chart below. From the 2000 top, the market dropped some 38% over a 33 month period into the bear market Phase I low in October 2002. This decline is marked in blue on the chart below. From that low the typical rally separating Phase I from Phase II began. Yes, there have been several false breaks in which it appeared that the decline into Phase II was underway. But, just as with the 1966 to 1968 rally, this rally has drug on and much of that is obviously because of the great re-inflation efforts of the FED. This re-inflation effort will likely serve only to stretch this bear market and the Secondary advances between each of the phases. In the end, I believe that the phasing will prevail. Also, just as with the 1966 to 1968 rally, bullish sentiment has set new records in association with this advance. Just as with the 1966 to 1968 rally the public is convinced that a new bull market is underway. Just as with the 1966 to 1968 rally the Dow theory is being questioned.

Thus far, my 2006 forecast has been right on the mark. I have guided subscribers through each crook and turn with my unique Cycle Turn Indicator. Based on the data that I see, the market is soon going to be facing some challenges. I have outlined the expectations for the remainder of 2006 in the June issue of Cycles News & Views. The July issue is now also available. If you are interested in a statistical and technical based source that also utilizes Dow theory and provides turn points for gold, the dollar, bonds and the stock market, then Cycles News & Views may be for you. Please see www.cyclesman.com/testimonials.htm.

Tim W. Wood
Cyclesman.com

Copyright © 2004-2008 by Tim W. Wood. All rights reserved.

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