Market and ETF Report – Dow Theory and Elliott Wave for Bear Markets, Two Breadth Indicators Have yet to Reach Extremes (Premium)

I rarely use Elliott Wave analysis, but there are some aspects that tie in with Dow Theory, of which I am a proponent. In fact, The Dow Theory by Robert Rhea is a must reading for technical analysts. Originally written in 1932, Rhea synthesized the writings of Charles Dow and William Peter Hamilton into a coherent theory. These insights are still relevant because human nature, and hence the markets, do not change.

The stock market discounts everything. This means that all known information is already priced into the market. Markets quickly appraise new information and adjust prices accordingly.

The trend is in force until proven otherwise. Moreover, neither the length nor the duration of a trend can be forecast.

Dow Theory is not perfect and does not always work. This is true of any indicator. Successful trading and investing requires serious study and hard work. It is also imperative to assess the evidence without any bias. See what is really there, not what you want to see.

There are three primary movements: primary, secondary and short-term fluctuations. The primary trend is the long-term trend, which can last several months or even years. Secondary trends are reactions against the primary trend, such as an advance within a primary downtrend or a decline within a primary uptrend. Short-term fluctuations are price moves that last a few days and represent noise.

A primary bear market is a long-term downtrend that can be interrupted by sharp or seemingly significant counter-trend rallies. Rhea’s exact words were “important rallies”. Rhea notes that a secondary advance can retraced “33 to 66 percent” of the prior decline.  

This is where Elliott Wave and Dow Theory overlap. There are five waves to an impulse decline (primary downtrend). Waves 1, 3 and 5 are down and in the direction of the bigger trend. Waves 2 and 4 are counter-trend advances that retrace 38.2 to 61.8 percent of the prior decline (Fibonacci numbers).

Primary bear markets are long-term downtrends caused by “economic ills” and there are three phases. The first phase is when traders give up on overpriced stocks that were bought at the end of the bull market. The second phase is when the economy actually deteriorates and business conditions worsen. The third phase involves selling of “sound securities, regardless of their value”. This third phase is also a capitulation phase.

Here we also have overlap with Elliott Wave and Dow Theory. In Elliott terms, the third wave stands out because it experiences the largest decline. This is the equivalent to the Dow Theory phase 2 of a primary bear market.

Getting back to basic Dow Theory, an uptrend is present when prices consistently hold above the prior low and exceed a prior high (higher lows and higher highs). A downtrend is present when prices consistently fail to exceed the prior high and decline below the prior low (lower highs and lower lows).

Double tops and double bottoms are “of little value in forecasting price movements and have proved to be deceptive more often than not”. The lesson here is do not go looking for a double bottom reversal in a downtrend.

A lot has changed since Charles Dow and Hamilton wrote for the Wall Street Journal. Dow penned his theories from 1889 to 1902 and Hamilton built on this from 1908 to 1929. Nowadays participants react to a plethora of news much faster, high frequency trading distorts daily price movements (and volume), and algorithmic trading has grown significantly. The markets are structurally different, but the nature of speculation has not changed, and will unlikely change in our lifetimes.