Lesson 30: DOW THEORY, CYCLES, NEWS AND RANDOM WALK
According to Charles H. Dow, the primary trend of the
market is the broad, all-engulfing "tide," which is interrupted by
"waves," or secondary reactions and rallies. Movements of smaller size are the
"ripples" on the waves. The latter are generally unimportant unless a line
(defined as a sideways structure lasting at least three weeks and contained within a price
range of five percent) is formed. The main tools of the theory are the Transportation
Average (formerly the Rail Average) and the Industrial Average. The leading exponents of
Dow's theory, William Peter Hamilton, Robert Rhea, Richard Russell and E. George Schaefer,
rounded out Dow's theory but never altered its basic tenets.
As Charles Dow once observed, stakes can be driven into the
sands of the seashore as the waters ebb and flow to mark the direction of the tide in much
the same way as charts are used to show how prices are moving. Out of experience came the
fundamental Dow Theory tenet that since both averages are part of the same ocean, the
tidal action of one average must move in unison with the other to be authentic. Thus, a
movement to a new extreme in an established trend by one average alone is a new high or
new low which is said to lack "confirmation" by the other average.
The Elliott Wave Principle has points in common with Dow
Theory. During advancing impulse waves, the market should be a "healthy" one,
with breadth and the other averages confirming the action. When corrective and ending
waves are in progress, divergences, or non-confirmations, are likely. Dow's followers also
recognized three psychological "phases" of a market advance. Naturally, since
both methods describe reality, the descriptions of these phases are similar to the
personalities of Elliott's waves 1, 3 and 5 as we outlined them in Lesson 14.
Figure 7-1
The Wave Principle validates much of Dow Theory, but of
course Dow Theory does not validate the Wave Principle since Elliott's concept of wave
action has a mathematical base, needs only one market average for interpretation, and
unfolds according to a specific structure. Both approaches, however, are based on
empirical observations and complement each other in theory and practice. Often, for
instance, the Elliott count can forewarn the Dow Theorist of an upcoming non-confirmation.
If, as Figure 7-1 shows, the Industrial Average has completed four waves of a primary
swing and part of a fifth, while the Transportation Average is rallying in wave B of a
zigzag correction, a non-confirmation is inevitable. In fact, this type of development has
helped the authors more than once. As an example, in May 1977, when the Transportation
Average was climbing to new highs, the preceding five-wave decline in the
Industrials during January and February signaled loud and clear that any rally in that
index would be doomed to create a non-confirmation.
On the other side of the coin, a Dow Theory
non-confirmation can often alert the Elliott analyst to examine his count to see whether
or not a reversal should be the expected event. Thus, knowledge of one approach can assist
in the application of the other. Since Dow Theory is the grandfather of the Wave
Principle, it deserves respect for its historical significance as well as its consistent
record of performance over the years.
Cycles
The "cycle" approach to the stock market has
become quite fashionable in recent years, coinciding with the publishing of several books
on the subject. Such approaches have a great deal of validity, and in the hands of an
artful analyst can be an excellent approach to market analysis. But in our opinion, while
it can make money in the stock market as can many other technical tools, the
"cycle" approach does not reflect the true essence of the law behind the
progression of markets. In our opinion, the analyst could go on indefinitely in his
attempt to verify fixed cycle periodicities, with negligible results. The Wave Principle
reveals, as well it should, that the market reflects more the properties of a spiral than
a circle, more the properties of nature than of a machine.
News
While most financial news writers explain market action by
current events, there is seldom any worthwhile connection. Most days contain a plethora of
both good and bad news, which is usually selectively scrutinized to come up with a
plausible explanation for the movement of the market. In Nature's Law, Elliott
commented on the value of news as follows:
At best, news is the tardy recognition of forces that have
already been at work for some time and is startling only to those unaware of the trend.
The futility in relying on anyone's ability to interpret the value of any single news item
in terms of the stock market has long been recognized by experienced and successful
investors. No single news item or series of developments can be regarded as the underlying
cause of any sustained trend. In fact, over a long period of time the same events have had
widely different effects because trend conditions were dissimilar. This statement can be
verified by casual study of the 45 year record of the Dow Jones Industrial Average.
During that period, kings have been assassinated, there
have been wars, rumors of wars, booms, panics, bankruptcies, New Era, New Deal,
"trust busting," and all sorts of historic and emotional developments. Yet all
bull markets acted in the same way, and likewise all bear markets evinced similar
characteristics that controlled and measured the response of the market to any type of
news as well as the extent and proportions of the component segments of the trend as a
whole. These characteristics can be appraised and used to forecast future action of the
market, regardless of news.
There are times when something totally unexpected happens,
such as earthquakes. Nevertheless, regardless of the degree of surprise, it seems safe to
conclude that any such development is discounted very quickly and without reversing the
indicated trend under way before the event. Those who regard news as the cause of
market trends would probably have better luck gambling at race tracks than in relying on
their ability to guess correctly the significance of outstanding news items. Therefore the
only way to "see the forest clearly" is to take a position above the surrounding
trees.
Elliott recognized that not news, but something else forms
the patterns evident in the market. Generally speaking, the important analytical question
is not the news per se, but the importance the market places or appears to place on
the news. In periods of increasing optimism, the market's apparent reaction to an item of
news is often different from what it would have been if the market were in a downtrend. It
is easy to label the progression of Elliott waves on a historical price chart, but it is
impossible to pick out, say, the occurrences of war, the most dramatic of human
activities, on the basis of recorded stock market action. The psychology of the market in
relation to the news, then, is sometimes useful, especially when the market acts contrary
to what one would "normally" expect.
Experience suggests that the news tends to lag the market, yet
follows exactly the same progression. During waves 1 and 2 of a bull market, the front
page of the newspaper reports news that engenders fear and gloom. The fundamental
situation generally seems the worst as wave 2 of the market's new advance bottoms out.
Favorable fundamentals return in wave 3 and peak temporarily in the early part of wave 4.
They return partway through wave 5, and like the technical aspects of wave 5, are less
impressive than those present during wave 3 (see "Wave Personality" in Lesson
14). At the market's peak, the fundamental background remains rosy, or even improves, yet
the market turns down, despite it. Negative fundamentals then begin to wax again after the
correction is well under way. The news, or "fundamentals," then, are offset from
the market temporally by a wave or two. This parallel progression of events is a sign of
unity in human affairs and tends to confirm the Wave Principle as an integral part of the
human experience.
Technicians argue, in an understandable attempt to account
for the time lag, that the market "discounts the future," i.e., actually guesses
correctly in advance changes in the social condition. This theory is initially enticing
because in preceding social and political events, the market appears to sense changes
before they occur. However, the idea that investors are clairvoyant is somewhat fanciful.
It is almost certain that in fact people's emotional states and trends, as reflected by
market prices, cause them to behave in ways that ultimately affect economic
statistics and politics, i.e., produce "news." To sum up our view, then, the
market, for our purposes, is the news.
Random Walk Theory
Random Walk theory has been developed by statisticians in
the academic world. The theory holds that stock prices move at random and not in accord
with predictable patterns of behavior. On this basis, stock market analysis is pointless
as nothing can be gained from studying trends, patterns, or the inherent strength or
weakness of individual securities.
Amateurs, no matter how successful they are in other
fields, usually find it difficult to understand the strange, "unreasonable,"
sometimes drastic, seemingly random ways of the market. Academics are intelligent people,
and to explain their own inability to predict market behavior, some of them simply assert
that prediction is impossible. Many facts contradict this conclusion, and not all of them
are at the abstract level. For instance, the mere existence of very successful
professionals who make hundreds, or even thousands, of buy and sell decisions a year
flatly disproves the Random Walk idea, as does the existence of portfolio managers and
analysts who manage to pilot brilliant careers over a professional lifetime. Statistically
speaking, these performances prove that the forces animating the market's progression are
not random or due solely to chance. The market has a nature, and some people
perceive enough about that nature to attain success. A very short term speculator who
makes tens of decisions a week and makes money each week has accomplished something akin
to tossing a coin fifty times in a row with the coin falling "heads" each time.
David Bergamini, in Mathematics, stated,
Tossing a coin is an exercise in probability theory which
everyone has tried. Calling either heads or tails is a fair bet because the chance of
either result is one half. No one expects a coin to fall heads once in every two tosses,
but in a large number of tosses, the results tend to even out. For a coin to fall heads
fifty consecutive times would take a million men tossing coins ten times a minute for
forty hours a week, and then it would only happen once every nine centuries.
An indication of how far the Random Walk theory is removed
from reality is the chart of the Supercycle in Figure 5-3 from Lesson 27, reproduced
below. Action on the NYSE does not create a formless jumble wandering without rhyme or
reason. Hour after hour, day after day and year after year, the DJIA's price changes
create a succession of waves dividing and subdividing into patterns that perfectly fit
Elliott's basic tenets as he laid them out forty years ago. Thus, as the reader of this
book may witness, the Elliott Wave Principle challenges the Random Walk theory at every
turn.
Figure 5-3
Next Lesson: Technical and Economic Analysis |
