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September 04, 2006

Dow Theory and Cycles
by Tim Wood

Recently I have received e-mails asking about cycles and Dow theory. I have addressed this before, but it seems that it's now time to look at this topic again. I have virtually every scrap of material written by Charles H. Dow, William Peter Hamilton and Robert Rhea and I want to confirm that cycles are definitely not a part of the Dow theory. I'll also add that head and shoulder formations, rising wedges, symmetric triangles and other technical patterns are not a part of the Dow theory. The McClellan oscillator, stochastics, RSI nor any other oscillator for that matter is a part of the Dow theory. Gold, the dollar, bonds or individual stock analysis is not a part of the Dow theory.

In a purist sense, Dow theory is a study of price action only as related to the Dow Jones Industrial Average and the Dow Jones Transportation Average. The Dow theory looks at such things as confirmation and non-confirmation, Dow's three movements, which is a means to separate and understand the short, intermediate and long-term movements, market phasing and value, to mention a few. Many think that the Utilities are a part of Dow theory, but they are not. As a matter of fact, the Utility average didn't even come to be until after Charles Dow's death. The Dow theory only looks at the Industrials and the Transports. For more on the history of Dow theory, please visit www.cyclesman.com/Charts&Quotes.htm and be sure to read the articles on William Peter Hamilton, Robert Rhea and George Schaefer as well.

My use of cycles simply allows me to quantify the moves within the broad context or framework of Dow theory. On page 42 of The Stock Market Barometer, William Peter Hamilton gives the dates and directions of the "Primary Trend." These dates correspond exactly with the price action of the "4-year cycle." In The Story of the Averages, Robert Rhea quantifies each "Primary Swing" and "Secondary Reaction" throughout this entire 200 page document. These dates also correspond with 4-year, seasonal and 22-week cycle highs and lows. So, regardless of the label we pin on these movements, these price movements are one in the same. The cycles work is simply another completely separate discipline that allows me to quantify the movements regardless of their names. Cycles allow for the development of expectations based on the quantification of prior moves of the same degree. Cycles allow one to look at the market in several dimensions, just as Charles Dow did with his three movement concept. The cycles work allows me to apply the historical quantifications in order to develop future expectations.

For the record, Dow, Hamilton and Rhea also spoke of the market having "three well defined movements" or dimensions. Hamilton said, "There are three movements of the averages, all of which may be in progress at one and the same time. The first, and most important, is the primary trend: the broad upward or downward movements known as bull or bear markets, which may be of several years' duration. The second, and most deceptive movement, is the secondary reaction: an important decline in a primary bull market or a rally in a primary bear market. These reactions usually last from three weeks to as many months. The third, and usually unimportant, movement is the daily fluctuation." Cycles are simply another way of looking at these movements.

As an example, the diagram below was taken from The Story of the Averages by Robert Rhea. Notice that Mr. Rhea labels the move from Point A to Point J as the Primary Bull Market and the move from Point J down to Point Q as a Primary Bear Market. From a cyclical perspective, the move from Point A to Point J was the move from the 4-year cycle low to the 4-year cycle top. The move from Point J down to Point Q was the move from the 4-year cycle top into the 4-year cycle low and the complete move from Point A to Point Q was one complete 4-year cycle. From a cyclical perspective the moves from Points A to C and from C to E were the movements of the short term trading cycle. Movement G to I was a 22-week cycle while the movement from Point E to Point I constituted one complete seasonal cycle.

Rhea labels the movement H to I as a "Secondary Reaction" in the Bull market. If I put my cycles hat on, that same movement becomes the downside piece of both a 22-week and a seasonal cycle. Movements from Point K to Point L and M to N were both "Secondary Reactions" in the Bear market. I might add that this advance from K to L topped out in only 3 months and there was a slight Dow theory non-confirmation at this top. From a Dow theory perspective, this non-confirmation was a warning and when the movement from Point L to M violated the Point K lows, the bear market was confirmed. Through my eyes as a cycles analyst, the upside piece of this move from Point K to L was both a 22-week and a seasonal cycle advance that topped in only 3 months. My work with cycles tells me that any seasonal cycle that tops out in 6 months or less has a 73% probability of moving below the previous seasonal cycle low, which was Point K. The same is also true for the advance between Point M and N in that M was expected to have been violated based on the cyclical quantifications. This same cycles work tells me that the average decline for all seasonal cycles topping in 6 months or less and that failed to move above their previous seasonal cycle high (in this case Point J) is 26.59%. In this case the decline that followed into the 4-year and seasonal cycle low, Point Q, was 45.22%. Dow theory does not tell us these things. Statistics such as these only come from cyclical or trend quantifications.

Cycles work is nothing more than a means of trend quantification and it can be used to confirm and complement Dow Theory. I could go on and on with each of these points, but there is really no need as my point should be clear. Cycles are not a part of the Dow theory. Cycles simply offer us another way of looking at the same movement, but through different eyes. If we have a working knowledge of both disciplines, we can use them together to confirm each other. As in the example above, once the move failed in only 3 months, the cycles work was warning us based on the quantifications of previous cycles. At the same time, the Dow theory was warning with its own non-confirmation. A Dow theory "Sell Spot" then developed as the Industrials formed a "line" into early January 1907. The trigger to sell was then hit with the downside break of this "line." The cycles work confirmed the break and offered a price target, which in this case proved to be conservative. Then, with the violation of Point K, Dow theory confirmed the bear market. As you should be able to see in this simple example, both disciplines have their place and can be used as separate tools to confirm and complement each other.

This is sort of like a Boxer deciding to also get his Black Belt in Karate. This would not minimize the knowledge or ability of the fighter. It would only enhance his skills by giving him more tools. What about someone who speaks English, French and German? Does this person also not have more tools? Does knowing more than one language corrupt or minimize the value of the other languages? What about the medical doctor who is also a naturopathic doctor? Is it not advantageous to have a doctor who could address an issue from both angles? Even while they are different approaches, both have their place. What about the mason who also learns carpentry skills? Has he not also increased his skill set and knowledge?

Separate, But Complementary Tools

The use of Cycles, Dow theory and the many other technical disciplines is really no different. Again, they are just separate tools. It was cycle theory that allowed me, in the summer of 2001 with the market still in the 10,500 range to forecast that the decline into 4-year cycle low in 2002 should occur below 7,400. It was cycle theory that allowed me to forecast the bottom in gold in 2001. It was cycle theory that allowed me to call the 2002 bottom in the CRB. It was cycle theory that allowed me to call the dollar top in 2002. It was cycle theory that warned me of the May 2006 high in gold. It was cycle theory that told me in July that unleaded gasoline and crude should begin moving lower.

It is the Dow theory that provides the backdrop of the overall Big Picture. It is the Dow theory that provides the understanding of bull and bear market phasing and where we are in this Big Picture. It is the Dow theory that provides important non-confirmations or warnings at most major cyclical turn points. It is the Dow theory that provides us with the setups at "Buy and Sell Spots."

It was the combination of both my trend or cycle quantifications and the Dow theory that I used to develop my 2006 forecast in which I stated in January we should first see the gain in 2006 and that the pain would follow in the last half of 2006. Also, In January I used statistical analysis to develop the projected market path for 2006. Thus far, that projection has been right on track with the market. It is cycle theory and my work with the Dow theory that is now telling me we are about to enter a window of great market risk. I hear many now saying that the 4-year cycle low was made in June/July, while others are expecting the low in October. According to my cycle/trend quantification, this is incorrect and as I see it the market has a surprise or two up its sleeve in regard to the phasing of the 4-year cycle.

It is the use of the two theories that complement each other, which in turn aids in the overall market analysis. Having knowledge in another discipline simply gives one yet another tool that can be used to help him better evaluate the task at hand. Again, to clarify, cycle theory is not a part of the Dow theory. These are indeed two completely different theories that can be used to confirm and complement one another. Rhea warned about the "Bastardization" of the Dow theory. I have to say that I could not agree more. The Dow theory has proven itself well for over 100 years and I believe that it should indeed remain pure. However, this is not to say that we can't use other tools in conjunction with the Dow theory as long as we keep them separate. These other tools may be in the form of oscillators, point and figure charts, Elliott wave, Gann or even cycles and statistical trend quantification.

Many are saying that after the Labor day weekend when volume returns to the market that it will be up up and away. Yet, others proclaim a decline into the fall. If you are interested in a statistical and technical based source that also utilizes Dow theory and provides statistical probabilities as to what should occur, then Cycles News & Views may be for you. I also provide web-based updates giving short and intermediate-term turn points on the stock market, gold, bonds and the dollar, utilizing my Trend and Cycle turn Indictors. The September issue will be available later this weekend and it contains all of the updated statistical probabilities and expectations for the stock market for the rest of 2006 and into 2007. A subscription also includes short-term updates three nights a week. 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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