Page 181 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Security Analysis and Portfolio Management

Notes The Dow Theory is built upon the assertion that measures of stock prices tend to move together.
If the Dow Jones industrial average is rising, then the transportation average should also be
rising. Such simultaneously price movements suggest a strong bull market. Conversely, a decline
in both the industrial and transportation averages, both move in opposite directions; the market
is uncertain as to the direction of future stock prices.
If one of the averages starts to decline after a period of rising stock prices, then the two are at
odds. For example, the industrial average may be rising while the transportation average is
falling. This suggests that the industries may not continue to rise but may soon begin to fall.
Hence, the market investor will use this signal to sell securities and convert to cash.

The converse occurs when after a period of falling security prices, one of the averages starts to
rise while the other continues to fall. According to the Dow Theory, this divergence suggests
that this phase is over and that security prices in general will soon start to rise. The astute
investor will then purchase securities in anticipation of the price increase.
These signals are illustrated in Figure 6.1. Part A that illustrates a buy signal. Both the industrial
and transportation average have been declining when the industrial starts to rise. Although the
transportation index is still declining, the increase in industrial average suggests that the declining
market is over. This change is then confirmed when the transportation average also starts to
rise.

Criticism of Dow Theory

Several criticisms are levelled against the Dow Theory.

1. It is not a theory but an interpretation of known data. A theory should be able to explain
why a phenomenon occurs. No attempt was made by Dow or his followers to explain why
the two averages should be able to forecast future stock prices.
2. It is not acceptable in its forecast. There was considerable lag between the actual turning
points and those indicated by the forecast.

3. It has poor predictive power. According to Rosenberg, the Dow Theory could not forecast
the bull market which had preceded the 1929 crash. It gave bearish indication in early
1
1926. The 3 years which followed the forecast of Hamilton's editorials for the 26-year
2
period, from 1904 to 1929. Of the 90 recommendations Hamilton made for a change in
attitude towards the market (55% were bullish, 18% bearish and 29% doubtful) only
45 were correct. Such a result an investor may get by flipping a coin).

Price Indicators of Market

The different price indicators which measure market movement are briefly explained below:
1. Breadth of Market: Breadth-of-market indicators are used to determine what the main
body of stocks is doing. It is computed by comparing market advances or declines. The
technician is interested in change in breadth than in absolute level. Several methods are in
vogue for measuring the breadth of the market. The most common ones are explained
here.

The breadth-of-market statistics are obtained by using the data of stock advances and
declines. The data of advances and declines are published daily in most financial and
national newspapers. Three simple methods are presented here:

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