The Dow Theory of Stock Prices 1942

THE DOW THEORY OF STOCK PRICES
Author(s): HAROLD S. BENJAMIN

Source: Social Research, Vol. 9, No. 2 (May 1942), pp. 204-224
Published by: The New School
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THE DOW THEORY OF STOCK
PRICES1
BY HAROLD S.
BENJAMIN
i
v_>/ur
security
markets still hold an
important position
in our
economic
system.
The volume of both investment and
consump-
tion is influenced
by
the movement of stock
prices,
and no
analyst
of the business
cycle
can
safely
overlook their
interrelationships
with
general
business conditions.
The Dow
theory attempts
to show that stock
prices
follow cer-
tain
patterns,
and that from an observation of these
patterns
definite conclusions can be drawn about future movements of
stock
prices
and even about
general
business conditions for some
time to come.
Today, nearly forty years
after the
theory
was first
advanced,
leading
financial
papers
still
interpret
stock market
action in its
light.
Therefore an
attempt
to
analyze
and
verify
the
theory may
well be
justified.2
The main
postulate
of the Dow
theory
is that there are at all
times three movements
occurring simultaneously
in the stock
market. If it is a bull market the
primary
movement lifts stock
lrThis article has
grown
out of discussions
during
a seminar on
security prices
conducted in the
spring
of 1939
by
the late Professor Fritz Lehmann of the Graduate
Faculty
of the New School for Social Research. The author is
greatly
indebted to
Professor Lehmann for advice and constructive criticism which
materially
aided
the
completion
of this
study.
2
The
theory
is named after Charles H. Dow,
who formulated its
principles
in a
number of editorials in the Wall Street
Journal
from 1900 until 1902. It was fur-
ther
developed by
William Peter Hamilton in his book, The Stock Market Barome-
ter,
which
appeared
in 1922,
and in his editorials in the Wall Street
Journal up
to the end of 1929. In recent
years
extensive studies of the
theory
have been
published by
Robert Rhea: The Dow
Theory (1932),
The
Story
of
the
Averages
(1934),
Dow's
Theory Applied
to Business and
Banking (1938).
Nine articles on
"Making
the Dow
Theory
Work"
by Sparta
Fritz,
Jr.,
and A. M. Shumate were
published
in Barron's from
August
21 to October 23, 1939.
THE DOW THEORY OF STOCK PRICES 205
prices
from the bottom to the
peak
-
to a
period
of
prosperity
and
rampant speculation;
and if it is a bear market the
primary
move-
ment carries
quotations
from the
top
to the bottom
-
to a
period
of
depression
and distress
selling.
While this broad movement is
under
way
the
secondary
movements are
occurring:
alternate
swings
in the direction of the
primary
movement,
and reactions.
While both
primary
and
secondary
movements are
going
on,
the
third
movement,
daily
fluctuations,
keeps changing
the market
level hither and thither. These three movements are
regarded
as
distinctly
different in
character,
and as the
only types
of move-
ments
going
on in the stock market.
The
length
of time which the
primary
movement
may
consume
was stated
by
Dow in 1900 to be "at least four
years."
Hamilton,
in
1922,
changed
this to "from a
year
to three
years."
But his
forecast,
like Dow's earlier
one,
was contradicted
by
the
subsequent
action of the
market,
and
Rhea,
in
1932,
had to limit himself to
the
pronouncement
that the
primary
market
"may
be of several
years
duration."
Equally vague
are the statements about the dura-
tion of
secondary
movements, which,
according
to
Rhea,
"usually
last from three weeks to as
many
months."
Nothing
definite is
said about the number of
days during
which
prices may
move in
one direction without
constituting
more than
day-to-day
fluctua-
tions.
Exact statements about the
amplitude
of the several
movements,
either in number of
points
or in relation to the market
price,
cannot be found in the
writings
on the Dow
theory.
We are
told,
however,
that a
primary
movement consists of at least two
swings
in the
primary
direction,
separated by
one
secondary
reaction;
the number of these
swings
and reactions
may
be much
larger,
but no
upper
limit is
given.
On the
amplitude
of the
secondary
movements the Dow
theory
states
only
that
prices during
a sec-
ondary
reaction
generally
retrace from 33 to 66
percent
of the
preceding swing
in the
primary
direction. From this it follows that
during
a bull market each low
point,
or end of a
secondary
down-
ward
reaction,
tends to be
higher
than
preceding
low
points,
206 SOCIAL RESEARCH
while within a bear market each
high point,
or end of a
secondary
reaction
upward,
tends to be lower than
preceding high points.
It does not follow
necessarily,
but it is also maintained
by
the Dow
theory,
that
generally, during
a bull
market,
each
high point,
or
end of a
secondary upward swing,
is
higher
than
preceding high
points,
and
conversely
for low
points
in a bear market.
The tool
employed by
the Dow theorist in
observing
the stock
market is the
Dow-Jones
schedule of
averages
of the
daily closing
prices
of industrial and of railroad stocks. These
averages
are
by
no means the best available index for the movement of stock
prices
over extended
periods.
The number of stocks included is rather
small. Selection and substitutions of stocks were made
arbitrarily.
During
certain
periods adjustments
for stock
split-ups
were
made,
but at other times such
adjustments
were not made. The
averages
are arithmetical
averages
of actual
prices,
thus
giving
undue
weight
to stocks
selling
at a
high price per
share. Nevertheless the
Dow-Jones averages may
be
accepted
as a
fairly good
indicator of
the movements in the
prices
of
leading
issues for the duration of
a
cycle.
The volume of stock market transactions is also considered
important.
A situation of
high
market
activity
on rallies and of
dullness on
declines,
according
to the Dow
theory, usually precedes
price
advances of
secondary magnitude.
A
high
sales volume on
declines and a small one on
advances,
on the other
hand,
is ordi-
narily
to be
expected
before
any secondary price
decline,
either
in a bull market or in a bear market.
With all these characteristics of the market movements in
mind,
the Dow theorist believes he is
capable
of
predicting
the
primary
trend. The rule for
forecasting
has been formulated
by
Rhea as
follows:3
"A
prediction
of a bull market in stocks and for forthcom-
ing expansion
in business
following
a
period
of
depression
is
afforded when both Industrial and Rail
averages:
(1)
Advance
substantially
into a
pattern
of sufficient dura-
3
Dow's
Theory Applied
to Business and
Banking, pp.
82, 83.
tion and extent to be
designated
as a
secondary
reaction
(rally)
in a bear market and then
-
(2)
Recede,
with
activity diminishing
as the decline
pro-
gresses, approaching,
but not
jointly penetrating
the bear
low
points,
after which
-
(3)
A further
rally,
with
increasing activity,
lifts both aver-
ages
above the
preceding secondary high point.
On the
day
both indicators close above their
stipulated pre-
ceding highs,
the Dow theorist is
given
his confirmation of a
change
in trend."
Precisely
the
opposite
is
necessary, according
to
Rhea,
to indicate a
beginning
bear market.
Quite
unrelated to the
hypothesis
of the three
movements,
and
its service as basis for
forecasting
the
primary
trend,
is the Dow
theory's
statement about "lines."
These,
according
to
Rhea,
are
"price
movements
extending
two to three weeks or
longer, during
which
period
the
price
variations of both
averages
move within a
range
of
approximately
five
percent."4
The Dow
theory
contends
that if both
averages finally
advance above the
upper
limits of the
line,
rising prices
are to be
expected
for a
while,
and that if the
line's lower limits are broken
by
both
averages
a short-run decline
will follow. No conclusions about the
long-term
trend are drawn
from lines.
The
analysis
of stock
price
movements contained in the Dow
theory
is based on
empirical
observation,
and neither Hamilton
nor Rhea shows much concern about the reasons for the outlined
behavior of the market. Yet if the causes for the several move-
ments could be
shown,
the contention that there
actually
are three
types
of movements
going
on in the
market,
and not four or six
or as
many
as
anyone
cares to
observe,
could be
greatly strength-
ened.
What, then,
are the
possible
forces behind the described
three movements?
4
The Dow
Theory, p.
15. A better formulation would
probably
be:
price
move-
ments of more than two weeks
during
which
period
neither
average changes by
more than
approximately
five
percent.
208 SOCIAL RESEARCH
The Dow theorists
appear
to hold business fluctuations
responsi-
ble for bull and bear
markets,
and this
explanation
will meet little
opposition except
from those
who, contrariwise,
blame business
fluctuations
solely
on the stock market.
Secondary
reactions,
it
seems,
are
regarded
as
correcting
movements
setting
in after the
swings
in the
primary
direction have carried
prices
farther than
warranted
by
business conditions.
Daily
fluctuations,
according
to
Rhea,5
depend
on "the news of the
day/'
These
explanations
are not
convincing.
That the influence of
business conditions
upon
the stock market is not confined to the
broad
swing
is
clearly
demonstrated
by J.
A.
Ross,
in a table
which
compares
the
Dow-Jones
industrial
averages
with the Cleve-
land Trust
Company's
index of industrial
production through
the
years
1929 to 1937.6
Analysis
of Ross's material indicates that
the observed stock
price
movements with an
average
duration of
two and one-half months were related not
only
to increases or
decreases in the level of industrial
production,
but,
even more
closely,
to
changes
in the
speed
of these increases or decreases. It
is found that in 31 out of 41 cases
rising
stock
prices
were accom-
panied by
an increase in the
speed
of
recovery
or a
slowing
down
in the
pace
of the
slump,
or
falling quotations
coincided with a
retardation of
recovery
or an
increasing speed
of business deteriora-
tion. Business
fluctuations, therefore,
can
by
no means be elim-
inated from the
possible
causes of movements of
secondary
extent
or duration. Nor is it at all
likely
that
changes
in sentiment
pro-
duce
only secondary
movements,
and never result in movements
of
greater magnitude
or in minor
day-to-day
oscillations.
And,
finally,
the news of the
day clearly
extends its influence
beyond
the field of
daily
fluctuations. Political
developments frequently
exert a
profound
influence
upon
stock
prices.
Movements of stock
quotations
are determined
by
the
opinions
about the
future,
and
by
the resources available for stock invest-
5
The
Story of
the
Averages, p.
111.
6
James
Alexander Ross,
Jr., Speculation,
Stock Prices and Industrial Fluctuations
(New
York
1938)
Table 43,
p.
377.
merit,
of all those who take an active interest in the stock market.
Opinions,
in
turn,
are influenced
by
economic and
political
facts,
by
the extent of
knowledge
or misinformation about such
facts,
and
by psychological
factors.
Regulations,
such as those
pertaining
to
margin trading,
have their
bearing upon
the amount available
for investment in
stocks,
and
so, too,
have
psychological
reactions,
inasmuch as an interest in stock
speculation arising among persons
who had
previously paid
no attention to the
exchange may vastly
increase the
capital supply
of the
community
of
potential
investors.
Rarely,
if
ever,
can a movement of stock
prices
be
explained by
a
single
one of the
underlying
factors. Some of the enumerated basic
factors
may
tend to
swing
backward and
forward,
but it is hard
to believe that their interaction would
produce
such a continuous
change
from bull to bear
market,
and such
regular
alternations
between
upswings
and
downswings
within each
primary
move-
ment,
as the Dow theorists believe
they
have found.
Strong
sta-
tistical evidence is
obviously
needed,
in the face of these theo-
retical
doubts,
to
prove
the existence of three
types
of movements
in the stock market.
n
A
good
deal of statistical work in
support
of the Dow
theory
has
been done
by
Robert Rhea. In Dow's
Theory Applied
to Business
and
Banking
he
presents
a
complete
record of all the
secondary
movements
accompanying
the ten bull and ten bear markets which
occurred between 1896 and 1938. For the
greater part
of that
period
he
supplies,
in The
Story
of
the
Averages, figures
on minor
movements that are not considered to be
secondary,
thus
greatly
facilitating
the task of
determining
whether the movements of
each
type
are similar in
important respects,
and different from
those of the two other
types.
The bull markets observed
by
Rhea
vary
in duration from as
short as 14 months to as
long
as 73 months. The shortest bear
market lasted for
only
8
months,
and the
longest
one 34 months.
The bull markets showed from two to ten
secondary
reactions
and,
210 SOCIAL RESEARCH
since each bull market starts and ends with a
swing upward,
from
three to eleven
swings
in the
primary
direction. In one of the
bear markets there were
eight
downward
swings interrupted by
seven
secondary
reactions. Two bear
markets, however,
consisted
of
only
two downward
swings
and one
upward
reaction.
Still
greater
are the
secondary
movements' variations in dura-
tion. In December 1904 a
secondary
reaction lasted
only
7
days
for industrials and 9
days
for
rails;
and in November and Decem-
ber 1928 a similar movement
lasting
for 10
days
in industrials
and 1 1
days
in rails is called a
secondary
movement. But the same
designation, "secondary
reaction in a bull
market,"
is
given
to a
movement in 1932-33 that lasted for
nearly
6
months,
and to a
movement in 1897-98 that continued for
6i^
months in industrials
and for more than 7 months in railroad stocks.
Secondary swings
at the
beginning
of bull markets consumed 22 calendar
days
in
1910-12,
28
days (railroads)
and 30
days (industrials)
in
1914-15,
16
days (industrials)
and 39
days (rails)
in
1938,
but more than a
year
in 1911-12 and
nearly
as much in
1925-26, 1926-27 and
1936-37.
Also in
regard
to the
amplitude
of fluctuations there seems to
be a
good
deal of arbitrariness in
designating
a movement as
pri-
mary, secondary
or
daily.
The
following
are
regarded
as
secondary
movements in bull markets
although
in industrials the reactions
carried the index below the
preceding
low
points.
Industrials Railroads
6/23/00
53.68
6/23/00
72.99
7/23
59.02
8/15
78.06
9/24
52.96
9/24
73.77
7/31/23
86.91
8/ 4/23
76.78
8/29
93.70
9/11
80.53
10/27
85.76
10/27
77.65
And the
following
movements,
despite
their
slightness,
are re-
garded
as
secondary upswings
and reactions in a bull market.
Underscored
figures
indicate the
beginning
of a
secondary up-
6/20/21
64.90
6/20/21
65.52
8/24
63.90
8/24
69.87
11/29
77.76
11/29
76.66
12/15
81.50
12/15
74.20
12/23
79.31
12/23
73.30
1/10/22
78.59
1/10/22
73.53
swing, according
to Rhea's
reckoning,
and also its end
-
the start-
ing point
of a
secondary
reaction. For each date
representing
a
turning point
in either industrials or rails the
figure
for the other
has been
supplied,
in order to indicate more
clearly
how
insig-
nificant the reaction was. Further
examples
of
slight
movements
regarded
as
secondary
reactions follow.
12/ 5/04
73.23
12/ 3/04
119.46
12/12
65.77
12/12
113.53
5/18/08
75.12
5/18/08
104.45
6/23
71.70
6/22
97.96
12/11/12
85.25
12/14/12
115.61
1/ 9/13
88.57
1/ 9/13
118.10
8/20/24
105.57
8/18/24
92.65
10/14
99.18
10/14
86.12
Let us
now,
for
comparison,
look at some of the movements
which,
in Rhea's
analysis,
are not called
secondary.
The succession
2/ 5/29
322.06
2/ 2/29
161.32
2/16
295.85
2/16
151.58
3/
1 321.18
3/
1 158.62
3/26
296.51
3/26
147.41
3/28
308.85
4/
6 152.16
4/
9 299.13
4/10
149.38
5/
4 327.08
5/
4 152.87
5/27
293.42
5/27
147.18
212 SOCIAL RESEARCH
of movements shown above is
regarded
as one
secondary
reaction.
Thus
price
rises such as the one
occurring
in the second half of
February,
or even the
longer-run
decline from the
beginning
of
February
to March 26 and the
subsequent recovery terminating
May
4,
are called
daily
fluctuations.
And not
only
in the frantic
year
1929 did wide
"daily
fluctua-
tions'* take
place.
In the
following
tabulation underscored
figures
again
indicate the
beginning
or end of what Rhea
regards
as
6/24/30
211.84
6/25/30
125.03
7/28
240.81
7/18
135.46
8/12
217.24
8/14
126.56
9/10
245.09
9/10
132.73
11/10
171.60
11/10
103.94
11/21
190.30
11/21
112.17
12/16
157.51
12/16
91.65
secondary
movements. The
rally
in
November,
which lifted
prices
10
percent,
is classified as a
day-to-day
movement. The
changes
in
price
level from
July
to
September
are
regarded
as
daily
fluctua-
tions,
and
strange
as it
may
seem
they
are
regarded
as
part
of an
upswing
in
industrials,
but as
part
of a
downswing
in rails.
The latter contradiction is
apparent
also in another
example.
If there is a factual difference between these two
types
of move-
1/ 5/32
71.24
1/ 5/32
31.36
1/15
85.88
1/15
41.30
2/10
71.80
2/9
32.76
2/19
85.98
2/16
40.45
2/23
80.26
3/
1 35.95
3/
8 88.78
3/
5 38.65
7/
8 41.22
7/
8 13.23
ments how is it
possible
that the rise in the first half of
January
1932 is
regarded
as
daily
fluctuations in industrials but as a full-
fledged secondary
movement in rails? It should not be
forgotten
that the Dow
theory
considers the stock market as a
unit,
and the
two
averages merely
as two instruments for the observation of
one
object.
Are the underscored
figures
in either series in this tabu-
lation
really turning points essentially
different from those not
underscored?
True,
Rhea's
reckoning
of
secondary
movements
pro-
duces the bear market
pattern:
the low
points
of
July
8 are below
the
preceding
low
points
of
January
5,
and the
high points
of
January
15 and March 8 are below the
preceding high points,
not
shown in the table. But if an
analyst
makes this result one of the
determinants for
distinguishing secondary
movements from
day-
to-day
fluctuations,
he includes in his
premise
what he set out to
prove.
The Dow
theory
contends that the described
pattern
will
be formed in a bear market
by
movements which somehow differ
from
daily
fluctuations as well as from the
primary
market move-
ments. The
only ways
ever mentioned in the Dow
theory by
which
they might
differ are
amplitude
and
duration,
but neither is a
consistent criterion in the
foregoing examples.
In the
following
tabulation the movement after
June
20 is re-
garded
as
part
of the last
downswing
of a bear
market,
as far as
1/15/21
75.14
1/15/21
77.56
5/
5 80.03
5/
9 75738
6/20
64.90
6/20
65.52
7/
6 69.86
7/
7 "72^9
7/15
67.25
7/15
70.32
8/
2 69.95
8/
2 75.21
8/24
63.90
8/24
69.87
industrial stocks are
concerned,
but in railroads it is taken as
part
of the first
upswing
in a new bull market. All movements between
June
20 and
August
24 are
relegated
to the
category
of
daily
fluctuations,
though
in
amplitude
and duration
they
are
certainly
greater
than in
many
cases where
secondary
movements are found.
The most curious
interpretation
is
placed by
Rhea
upon
the
following
market
movements,
all of them
regarded
as
just
one
secondary
movement,
a reaction in a bull market. It would better
agree
with Rhea's
general interpretation
to consider the under-
214 SOCIAL RESEARCH
9/ 7/32
79.93
9/ 3/32
39.27
9/19
65.06
9/14
29.71
9/21
75.16
9/24
36.95
10/10
58.47
10/10
23.65
10/19
65.74
10/20
29.76
11/
3 58.28
11/
3 24.70
11/12
68.04
11/12
30.61
12/
3 55.83
12/
3 24.33
12/14
61.93
12/14
28.16
12/22
56.55
12/23
24.05
1/10/33
64.35
1/11/33
29.52
2/27
50.16
2/25
23.43
scored dates as
turning points
between
secondary
movements. We
would then have a
pattern
that conforms
fairly
well with the Dow
theory's concept
of a bear
market,
its low
points tending
to be
below
previous
low
points
and its
high points
below
previous highs.
Unfortunately,
however,
this
pattern
occurred
while,
in Rhea's
opinion,
not a bear but a bull market was under
way,
a bull market
that was to
carry
the railroad
average
from its all-time low of 13.23
in
July
1932 to 64.46 in March
1937,
and industrial
stocks,
over
the same
period,
from 41.22 to 194.40. Rhea could have called
the movement
represented
in the above table a
complete
bear
market. This would have been the shortest bear market on
record,
only b'/2
months,
and it would have
compelled
the
interpreter
to
call the
preceding
2 months
upswing
a
complete
bull market.
7/26/10
73.62
7/26/10
105.59
8/17
81.41
8/17
115.47
9/
6 78.45
9/
6 110.57
10/18
86.02
10/18
118.44
12/
6 79.68
12/
6 111.33
2/ 4/11
86.02
2/ 7/11
119.97
4/22
81.32
3/
2 115.75
6/19
87.06
7/21
123.86
9/25
72.94
9/27
109.80
9/30/12
94.15
10/ 5/12
124.35
The so-called bull market of 1910-12 likewise confronts us with
a movement that fits neither the
concept
of a
secondary
reaction
nor that of a
complete
bear market. Its
secondary
movements are
given by
Rhea as shown on the
preceding page.
The
irregularity
is the decline from
June
to
September
1911,
which carried both
averages
below the low
points
of all
previous
reactions,
and carried
the industrial
average
even below the bottom of the bear market
which terminated in
July
1910.
We
may
define a bull market as a
period during
which stock
prices
advance from a low
point
not fallen short of within a
year
previous
or
subsequent,
to a
high point
not
surpassed
within a
year previous
or
subsequent;
and a bear market
may
be defined
inversely.
If we then use the
Dow-Jones averages
as our tool of
observation Rhea's
figures
for
number,
duration and
amplitude
of bull and bear markets are found to be correct. But the assertion
that the
ups
and downs
occurring during
these
primary
move-
ments can be
separated
into two
distinctly
different
categories,
secondary
and
daily, appears
to be
entirely
without foundation.
The statement of the Dow
theory
that
during
a bull market
high
points
tend to be
higher
than
preceding high points
and low
points higher
than
preceding
low
points,
while in a bear market
low
points
tend to be below
previous
low
points
and
high points
below
previous high points,
would be
significant only
if the ex-
ceptions
were
few,
for
general
tendencies of this kind are to be
expected
in
any irregular upward
or downward movement.7 Rhea's
7
To the reader who doubts
this, one of the
following experiments
is recom-
mended. Cast a die, and record the results on a
chart,
moving
one
square
to the
right
each time the die is
cast, and 3
squares up
on a
6, 2
squares up
on a 5,
1
square up
on a
4,
1
square
down on a
3, 2
squares
down on a
2, 3
squares
down on
a 1. Or take
any irregular
series of
figures
from 0 to
9, such as the last
digit
of the
prices
of various securities as
they appear
in the
daily papers,
and record them on
a chart in this
way:
move one
square
to the
right
each time and
1, 2, 3,
4 or 5
points up
on
5, 6, 7, 8, 9,
respectively,
and 1 to 5
points
down on the numbers 4, 3,
2, 1, 0. After
something
like 200 moves it will be
possible
to discern stretches
during
which the curves show a decided
upward
trend, with
high points tending
to be
higher
than
preceding high points,
low
points higher
than
preceding
low
points.
And there will be stretches with a marked downward
tendency,
where the
oppo-
site will be found.
216 SOCIAL RESEARCH
compilations
seem to indicate that the
exceptions
to his rule were
hardly
more than 5
percent.
But when we examine the small move-
ments that were called
secondary,
and the extended
changes
in
market level that were classified as
daily
fluctuations,
it becomes
obvious that within a
large
border
region
movements were called
secondary only
if the
resulting
chart conformed to
preconceived
ideas. The same holds true for the
allegation
that reactions
gen-
erally
retrace from one-third to two-thirds of the
preceding
move-
ment in the
primary
direction. In this case the
exceptions
are
frequent
even in Rhea's own
compilations,
and
they
become
numerous
enough
to render the rule
meaningless
if we reinstate
as
secondary
movements all those fluctuations that were
deprived
of the name not because
they
were small or short-lived but because
they
did not behave as
anticipated.
in
No
attempt
has ever been
made,
as far as this writer is
aware,
to
prove statistically
the Dow
theory's
assertion that valid conclusions
about future market movements can be drawn from a
comparison
of the turnover of stocks on
days
of
advancing
and
days
of declin-
ing prices.
I have tried to test this contention
by computing,
for
periods
around the
top
of the bull markets of
1899, 1909, 1919,
1929 and
1937,
the
average
volume of shares traded on full trad-
ing days
when both the industrial and the railroad stock indices
advanced,
and on
days
when both indices declined. The
periods
selected were
always
terminated before a decisive break in the
On Advance On Decline
1899
568,000
shares 24
days 581,000
shares 25
days
1909
898,000
27
866,000
23
19198
1,558,000
18
1,557,000
10
1929
4,379,000
12
4,770,000
9
1937
2,495,000
20
2,506,000
14
8
For 1919 the
comparison
was made between
days
when the industrial
average
rose or
fell, since the railroad
average
-
because of
government management
of
the roads
-
did not reflect
general
stock market conditions at that time.
market occurred. The results are shown above.
According
to the
theory
a heavier volume is to be
expected
on
declines,
indicating
the imminent reversal of the
upward
trend.
Actually
we find this
situation but
twice,
while in two instances the
average
volume is
almost
exactly equal
and in one it is
greater
on the advance.
The test was
repeated
in the
following
calculation,
the
only
1899
598,000
shares 8
days 662,000
shares 6
days
1909
694,000
6
680,000
4
1919
1,612,000
6
1,639,000
5
1929
3,940,000
4
4,314,000
8
1937
2,473,000
7
2,539,000
5
difference
being
that the observation was limited to a shorter
period, immediately preceding
a distinct break in the market.
Here the results conform somewhat better to the
rule,
although
the
tendency
toward a heavier volume on
days
of
falling prices
is
not a
strong
one. The same test was
applied
to four other
periods,
1898-99
586,000
shares 24
days 576,000
shares 11
days
1915
596,000
31
506,000
24
1924
1,472,000
17
1,479,000
6
1930-31
2,068,000
12
1,990,000
7
each
constituting
the first half of a
continuing upswing.
Here we
find,
in
conformity
with the
theory, greater activity
when
prices
advance,
but
again
not much
greater
and not without
exception.
For
declining
or stable markets
preceding
an
upswing,
when
according
to the rule a heavier volume is to be
expected
on
days
of
rising prices,
the
following pattern
was found.
1898
236,000
shares 3
days 263,000
shares 6
days
1926
1,006,000
3
965,000
4
1938
Mar.-Apr. 932,000
3
1,363,000
5
1938
June 480,000
4
347,000
5
1939
906,000
4
1,363,000
5
218 SOCIAL RESEARCH
Only
in the
figures
for
periods constituting
the first half of
continuing
declines is there no
exception
to the rule.
1907
522,000
shares 7
days 567,000
shares 11
days
1912
467,000
16
533,000
18
1926
1,939,000
2
2,095,000
5
1932
1,196,000
4
1,472,000
17
Thus we
may say
that while the observations of the Dow
theory
with
regard
to market
activity appear
to be
basically
correct,
the
tendencies are not
very strong, exceptions
are
frequent,
and a
reversal of the market trend often occurs without
any prior
indi-
cation in the number of shares sold. The volume of transactions
when
prices
rise and when
prices
fall
may give
a clue as to the
attitude of the
investing public,
but since the attitude
prevailing
today
is not the
only
factor concerned in the
prices
of
tomorrow,
volume
changes
can
hardly
be
expected
to
predict
with
depend-
ability
tomorrow's
prices.
IV
If a trader had followed the Dow
theory consistently
since
1897,
and had
interpreted
all market movements in the same
way
as
Rhea did in his
retrospective
market
analysis,
he would have
made ten
purchases
and ten sales in
forty years,
and the result
would have been as follows:
$100
invested in industrials on
June
28, 1897,
would have
grown
to
$3603.88
on
September
7, 1937,
and the same amount invested in rails would have increased to
$533.24.9
Over the same
forty-year period
$100
invested in in-
dustrials would have increased to
$502. 08,10
and
$100
invested in
railroad stocks would have shrunk to
$79.95
if held uninter-
ruptedly.
The loss in income which the Dow theorist would have suffered
by keeping
his fund uninvested for as much as thirteen and one-
9Dow's
Theory Applied
to Business and
Banking, p.
102.
1U
*or the
purpose
or this
computation
the Dow-
Jones
industrial
average
had to
be corrected to eliminate the break that was allowed to occur in 1914.
half out of the
forty years
is,
of
course,
by
no means
negligible.
Corrections
ought
to be made also for commissions and stock
transfer
taxes,
and for the fact that
actually
the Dow theorist can
sell or
buy only
after his
selling
or
buying signal
has been estab-
lished
by
the
prices
at the end of the
preceding day's
stock market
session,
while Rhea's
computation
is based on the
assumption
that
he sells or
buys
at the
price
which itself constitutes the
signal.
But
the most
important objection
to Rhea's
computation
as a
proof
of
the
validity
of the
forecasting
rule arises from the fact that the
computation
is based
upon
the
phenomenon
called
secondary
re-
action. If the
foregoing analysis proved anything
it
proved
that
these
"secondary
movements" are
indistinguishable
from move-
ments that are
designated
as
day-to-day
fluctuations
by
the Dow
theorists.11
11
One more
example may
demonstrate how the artificial distinction between
secondary
and
day-to-day
fluctuations can be misused in
retrospective
market
analysis.
Here
again
the underscored
figures
denote the
turning points
between Rhea's
"secondary
movements." The
changes
from
September
to November are classified
9/ 3/29
381.17
9/ 3/29
189.11
10/
4 325.17
10/
4 168.26
10/10
352.86
10/11
178.53
11/13
198.69
11/13
128.07
12/
7 263.46
12/
9 151.95
12/20
230.89
12/20
143.02
4/17/30
294.07
3/29/30
157.94
as
secondary swings.
A
selling signal
therefore
appears
on October
23, 1929, when
both
averages,
after
failing
to
surpass
the
September highs,
break
through
the
level of October 4. The movements after November 13 are called
day-to-day
oscil-
lations, in
spite
of the fact that the smallest of
them, the
price
decline in De-
cember
1929, exceeds both in
amplitude
and in duration the movement between
October 4 and October 10 or 11. The reason for this
inconsistency
is obvious. If
we
designate
as
secondary
the movements between November 1929 and
April
1930
we will be confronted with a
buying signal
on
February
7, 1930, when the aver-
ages,
after
failing
to break
through
the November
lows,
surpass
the
high points
of
December 7 and 9. A
purchase
at that
time, however, would have reduced the
total
profits
of the Dow theorist in the
previously
mentioned
computation by
more
than one-fifth. If the
inconsistency
is remedied
by calling
all movements in the
foregoing
table
day-to-day
fluctuations, the
profits
over the
forty-year period
will
be reduced
by
as much as one-fourth or even
one-third,
depending upon
the in-
terpretation placed upon
some
subsequent changes
of the market level.
220 SOCIAL RESEARCH
It should be
noted, too,
that the
forecasting
rule limits itself
to the time
following
a
period
of
depression
or a
period
of
pros-
perity.
In
doing
so it
presupposes
that there will
always
be times of
prosperity
and of
depression,
and that
they
will
generally
be
recog-
nized as such when
they
occur. Did the
investing public,
in
1929,
believe that
depressions
were bound to recur? Did
they
know,
in
1932 and
1933,
that some measure of
prosperity
would return
without a fundamental
change
in our economic
set-up
which
might seriously impair
the value of securities? With that knowl-
edge nobody
would have needed the
guidance
of the Dow
theory
to make
profits
from
security
transactions
during
those times. It
was the
widespread
belief that the
ordinary
laws of economics were
no
longer
valid which
kept people
from
selling during
the
specula-
tive boom of
1929,
and from
buying during
the worst
depression
months of
1932,
yet
the Dow
theorist,
in the
preceding computa-
tion,
derives the bulk of his
profits
from transactions in these two
periods.
If we limit the
computation
to the more than
thirty-two years
from
June
28, 1897,
to October
23, 1929,
we find that investments
of
$100
in industrial stocks and
$100
in railroad stocks would
have
grown, respectively,
to
$933
and
$300
if held
uninterruptedly
over the full
period,
to
$1840
and
$485
if
managed according
to
the Dow
theory, assuming
that the
purchases
and sales were made
at the
prices
which themselves constituted the
signal
to
buy
or
to
sell,
and to
$1570
and
$442
if
managed according
to the Dow
theory,
the
purchases
and sales
being
made at the
closing price
of
the next
following day.
The difference becomes still smaller when
the lower interest return on the Dow theorist's investment is
taken into account. And to achieve even such a moderate result
the Dow theorist would have had to
perform,
for
thirty-two years,
the
impossible
task of
distinguishing insignificant "day-to-day
fluctuations" from
significant "secondary
movements,"
in the same
way
as Rhea did with the aid of
hindsight.
Not
always,
moreover,
is the Dow
theory's forecasting
rule
pre-
sented in terms so cautious as those
employed by
Rhea in his at-
tempt
to
prove
the rule's
validity by applying
it to the
past.
The
limitation
referring
to the time "after a
period
of
depression"
or
"after a
period
of
prosperity"
is often
neglected,
and clues about
the future trend are
sought
at all times. If there is a
protracted
sidewise movement the rule about lines is
utilized, which,
how-
ever,
does not
purport
to show more than a short-term trend. In
other instances the commonsense rule that
during
a
rising
market
high points
tend to exceed
previous highs
and low
points
to be
above
previous
lows,
while in
declining
markets low
points
tend
to be below
previous
lows and
high points
below
previous highs,
is reversed.
In The Dow
Theory
Rhea has informed us
(p. 75):
"Successive
rallies
penetrating preceding high points,
with
ensuing
declines
terminating
above
preceding
low
points,
offer a bullish indica-
tion.
Conversely,
failure of the rallies to
penetrate previous high
points,
with
ensuing
declines
carrying
below former low
points,
is
bearish." In this formulation of the
forecasting
rule the distinc-
tion between
secondary
movements and
day-to-day
fluctuations
has
apparently
been
dropped,
and with it the whole
theory
about
the three movements. What remains is a definition of a bull
market and of a bear market. If we knew how
long
bull or bear
markets thus defined
may possibly
last,
or how far
they may carry,
we would be able at certain times to forecast the market trend.
Unfortunately
the Dow
theory
does not tell us
anything
about
that.
v
There remains for verification the Dow
theory's
statement about
lines,
which
says
that a market advance or decline
beyond
the nar-
row limits established
during
at least two weeks of market
stability
can be relied
upon
to continue for a while.
The
psychological background
of this rule is obvious.
Nothing
makes
people
more bullish than a
rising
market,
nothing
makes
them more bearish than a
price
decline.
Many
a man who has for
some time considered
buying may
do so when he sees a
price
ad-
222 SOCIAL RESEARCH
vance after weeks of
stability,
and vice versa. As
previously
stated,
however,
psychological
factors are not the
only
ones
contributing
toward movements of the
market,
and new facts
may change
the trend.
Statistical
analysis
bears out this
expectation.
From 1897 to
1932 Rhea,
in The
Story of
the
Averages,
finds 26 lines that are
finally
broken on the same side
by
both
averages.
Of these lines
19 occurred
by
1914,
and
only
7
during
the
following eighteen
years.
In a
single
case Rhea admits that the market went
contrary
to
expectations.
In some other instances the movements in the
expected
direction were
extremely
small. From March 2 to
April
29, 1911,
for
example,
the industrial
average stayed
between 84.13
and
81.32,
while rails remained between 118.73 and 115.75. Rails
penetrated
the
upper
side on
May
1,
and when industrials followed
on
May
16 the rail
average
stood at
119.96,
whereas industrials
had reached 84.63.
During
the
following
months industrials ad-
vanced as much as 2.43
points
and rails
gained
a maximum of 3.90
points
before declines of about 14
points
occurred.
From
July
19 to
September
14, 1900,
industrials maintained a
level of 56.80 to
59.02,
and railroad stocks remained between
75.75 and 78.06. On
September
15 the line was broken on the
downside
by
both
averages.
The
succeeding
decline, however,
was
limited to 3.60
points
in industrials and 1.61
points
in
rails,
and
a
strong
bull market followed.
With some
diligent
search,
lines can be found that were not
recorded
by
Rhea. From
September
8 to October
9, 1924,
for
instance,
101.13 and 104.68 denote the limits for the movements
of industrial
stocks, 88.26 and 90.71 those for rails. On October 14
of that
year
industrials,
following
the lead of railroad
stocks,
pene-
trated on the
downside,
but the lows touched on that date were
not reached
again
for
nearly
seven
years.
Lines are not defined
exactly enough by
the Dow theorists to
allow of
only
one
interpretation
in
any given
instance. Therefore
it is
hardly possible
to make a statistical
comparison
of the num-
ber of cases in which the rule
proves right
and those in which it
does not. The
examples given, together
with theoretical considera-
tions,
should be
sufficient, however,
to show that not too much
emphasis
should be
placed upon
the
reliability
of lines as a fore-
caster of the short-term trend.
VI
In
appraising
the Dow
theory
as a whole it
appears
that some of
its observations about the stock market are
right,
some
wrong.
Correct is the observation that when the
general
market trend
points upward
a
higher
volume of transactions
usually
occurs on
days
of
advancing prices
than on
days
of
falling prices,
and vice
versa when there is a
general
downward
tendency.
Correct also
is the statement that a trend which
develops
after a
period
of
stability
has a
tendency
to continue for a while. Both of these
observations refer
only
to the short-term market trend.
They
are
a
help
to the
professional
trader who
pays
more attention to short-
term
prospects
for the entire market or for individual securities
than to
long-term speculations.12
Unproved
and
untenable, however,
are the Dow
theory's
more
fundamental assertions about a
regular cyclical
movement of stock
prices,
and about the two different kinds of minor fluctuations
that
accompany
these
regular cyclical swings.
In the
price
move-
ment from a low
point
not fallen short of within a
year previous
or
subsequent,
to a
high point
not
surpassed
within a
year
before
or
after,
there is
nothing
which makes that movement one
organic
whole
consisting
of various
integral parts.
There is
nothing
on
the chart of such a bull market that
essentially
differs from a
rising
stretch in other chance curves. Therefore there can be no means
12
Another such
help
to the short-term
speculator
has arisen under the influence
of the Dow
theory
itself. Whenever a decline in stock
prices
has failed to
pene-
trate a
previous
low
point,
and
rising prices bring
the market close to the
pre-
ceding high point, only
a
penetration
of that
high point
is
necessary
to
produce
a
great
number of
buying
orders from the
many
believers in the Dow
theory.
If the
insider sees in the course of the market session that this condition will
probably
be
fulfilled
by
the
day's closing prices,
he can
place
his orders ahead of the
crowd,
and can sell a
day
or two
later, after the
theory's
adherents have further raised the
market level.
224 SOCIAL RESEARCH
of
diagnosing
a bull or bear market as such in its
early stages,
or
of
benefiting
from the
knowledge
that this bull or bear
market,
once under
way,
must continue.
The Dow
theory's
belief that
general
business conditions can
be foretold from an
analysis
of the stock market is based on the
knowledge
that
great changes
in the level of stock
prices usually
accompany
similar
changes
in business conditions. Therefore the
claim to
possession
of a
key
for
predicting
business conditions falls
with the claim to
possession
of a
key
for
predicting
the
long-term
market trend.
The Dow
theory, basically,
is
merely
a reflection of economic
theories about a
regular
and unalterable
cyclical
movement of
business conditions. But these economic theories have
long
since
been discarded
by leading
economists.
(New
York
City)

The Dow Theory of Stock Prices 1942

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The Dow Theory of Stock Prices 1942

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THE DOW THEORY OF STOCK PRICES

Author(s): HAROLD S. BENJAMIN

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