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August 02, 2006

Lessons from The Past
by Tim Wood

As a market historian, it is my belief that if we study the markets of the past, we can gain valuable insight into the future. If you think about it, it's difficult to judge a given situation if you haven't experienced it before. Making decisions about something we have no experience with requires research and the gathering of historical data. So, it's logical to me that we can gain our experience in one of two ways. We can learn from the school of hard knocks and let unfamiliar situations teach us the hard way, or we can learn from history. Both Dow theory and cycle analysis are really nothing more than studies of past market behavior. Then, when we see a similar behavior we have some indication as to the outcome of that setup based on the market history of the past. Basically, this is a means of "profiling" the market.

However, simply studying the past is not exactly the same as first hand experience and as we all know, history does not repeat itself exactly. But, it does repeat in a general sense and I would much rather be armed with the lessons of the past than not. Also, if you think about it, our formal education is really nothing more than the study of history. Our teachers taught us to be the engineer, doctor, accountant, lawyer, carpenter, mechanic or whatever, largely through the study of history. The engineer learns design structure through the experience of his predecessors. The doctor is taught based on analytical and diagnostic principles that were learned and developed by his predecessors as well. The lawyer studies case law and so forth. If you think about it, a large part of any profession is learned through the study of history. Yet, it seems that most participants in the market make very little, if any, study of market history. You often hear people say that they think this or that about a particular market, but it is rarely ever based on any serious study. People will spend years learning a skill or getting an education, but are generally unwilling to make much of an effort to truly study the markets and prepare themselves properly as investors.

William Peter Hamilton, 1922 wrote, "The small speculator, and more particularly the small gambler, suffers at the hands of the professional. He is a follower of "tips" and "hunches." He has made no real study of the things in which he trades. He takes his information without discrimination at second hand, lacking the ability to distinguish good from bad."

Robert Rhea, 1932 wrote, "It is doubtful whether any trader has ever operated successfully over a long period of years unless he has devoted much time and study to the work."

Just as William Peter Hamilton and Robert Rhea observed some 80 years ago, most people operating in the market today have never seriously studied market history. Few truly understand Dow theory or the phasing of bull and bear markets. I have even been told that Dow theory is no longer relevant for this reason or that. Robert Rhea was told the same thing and on one such occasion he wrote, "I respectfully suggest that Dow's theory is best learned through repeated reviewing of both ancient and current movements. The primary objective of these letters is to encourage readers to learn to recognize the voice of the averages; to become their own oracles, and to learn to ignore the unorthodox and misleading explanations of Dow's theory written by men, either too lazy, or who lack the mentality, to master a simple subject."

When it comes to cycles it seems that many think cycle analysis is some form of voodoo. Yes, it is true that cycle analysis is not a part of Dow theory, but it does offer a way of trend quantification that can be used to profile the market and develop quantifiable expectations for the future.

All of these misunderstandings are simply a result of not having studied market history nor current market conditions. Rather, most people operate on tips and hunches just as Rhea stated above. Given the duration of the preceding bull market it is understandable that few truly grasp the bigger picture. The bull market that ran from the 1974 low into the 2000 top trained everyone to "buy the dip" and to "hold for the long haul." As a result, this is all they know and understand. Now here we sit some 6 years later and all is well, Right?

Operating in market conditions that you have never seen before or studied before is like a lawyer trying to defend someone, yet he has never made a real study of case law. The lawyer in this example would have no basis or grounding in which he could build his case. It is my opinion that the vast majority of the talking heads on TV are completely ignorant of long-term market history. All they know is what real life experience has taught them over the last couple of decades. Now that times are changing, they can't see it because they have no historical grounding or experience to draw from.

On October 23, 1929 the great Dow theorist, William Peter Hamilton, saw that the bear market had been signaled. The next business day, Hamilton wrote his famous editorial about that signal in the Wall Street Journal entitled A Turn In The Tide. On May 27, 1933 Robert Rhea, my favorite Dow theorist, wrote that the new bull market had been confirmed. These guys were able to make these calls because they knew market history and as a result they knew what the turning point looked like.

Now, I'm not saying that just because I'm a market historian and Dow theorist that I have all the answers. What I am saying is that history is our best teacher and in believing that, I have not limited my study of the averages to recent history. I have analyzed the markets from 1896 to present and as a result I feel fairly confident that Dow theory will once again hold true. Furthermore, I am fairly confident of my trend quantification work because it tells me what the probability of a given outcome is.

One consistency that I have found in my study of the great Dow theorists of the past is that they primarily operated in the direction of the primary trend. I could not agree more. Trying to buy a bear market rally is no different than trying to short the declines in a bull market. There is no way to know how far these counter trend rallies will carry. It's really like swimming against the tide and thus, much more speculative. Why swim against the tide when we can swim with it? The great Dow theorists of the past would stand aside for months while patiently waiting for the market to set up. I want to offer you the following quote from the book Making The Dow Theory Work 1939, by Sparta Fritz and A.M. Shumate.

"The most elusive move in the market cycle, aside from the minor moves, which we are disregarding, is the secondary rally in a bear market. It is usually expected more than once before it actually occurs, and runs its course abruptly, to finish just about the time that the chronic bulls begin to take heart. It would be labeled the most dangerous chance in the market cycle."

Also in 1934 Robert Rhea described a particular market situation as follows: "I am not attempting to classify this action beyond repeating that the price movement was reflecting uncertainty, and this is not intended as an apology for the unreliability of the averages in this instance. There are many formations where the averages perplex us with their uncertain movements, and that is as it should be. If they were talking all the time and telling the truth, one would have an infallible device for beating the market, and one which would not be in the public interest; moreover, the market itself would soon be destroyed."

As you can see, even the great Dow theorists of the past experienced moments of uncertainty when the market would toy with their emotion. However, it was market history and their discipline that allowed these great operators to navigate the markets of their day. In my opinion history also remains our best teacher today and I can tell you that the "Stock Market Barometer" is beginning to see stormy conditions. Furthermore, my statistical quantifications are telling me that the market risk is now high.

If you are interested in a technical based service that utilizes market history in order to develop statistical expectations for the future in the stock market, gold, the dollar and bonds, 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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