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					Market Analysis – Dow Theory                                                                       Page 1


                                           An Analysis of the US Stock Market
                                                         By KT Tsai, Ph.D.
                                               http://frontierinformaticsservice.com


Dow Theory
 1. Market averages discount everything
      a. This is the foundation of stock valuation. The stream of future earnings,
         dividends, or cash flow are discounted by a factor which includes the
         expected return, inflation, or other factors deem important to value the stock.
         Since everything in this formulation is a best guess or estimate, unless it is
         extremely lucky, it is very rare for anyone to pin down the exact market
         valuation.

2. Market has three trends
     a. Market technicians would like to believe that stock market has three trends,
        namely, long-term, mid-term, and short-term trends. This can be
        hypothesized as the under current, the wave, and the ripple of the great ocean.
        There is no definitive definition of long, mid, or short term. However, a
        reasonable criteria for long term is 1 year, mid-term is 1 quarter, and short-
        term is 3 weeks. Following three panels correspond to the decomposition of
        DJIA with respect to these 3 trends.




                  DJIA - Weekly Close & 10 , 24 , 40 Weeks Moving Average
                                           11000
                    Weekly Closed Prices

                                           10000
                                           9000
                                           8000




                                            01/07/2002         09/01/2003          04/25/2005
                                                                   Time in Weeks




http://frontierinformaticsservice.com/Dow-Theory                                                11/15/2010
Market Analysis – Dow Theory                                                                                                                Page 2




3. Major trend has 3 phases
     a. Like the life cycle of a flower, it first buds, then blossom, and follows by
         decay. Similarly, the market has 3 phases. In the very beginning, the most
         astute investors with better information or luck start to accumulate or buying
         before the general public. By tracking the smart money or through technical
         analysis, the next group of informed investors start to participate and this
         second phase will generate more market action and information about the
         market status. With the media’s help to disseminate the market activities, the
         least informed investors start to participate in the market.

4. The averages must confirm each other.
      a. This refers to the relationship between DJIA and the DJ Transportation Index.
         It is generally believed when economy is good and the productivity is high,
         one needs to have high utilization of transportation to ship the goods. When
         this concordance is not existent, it generally signals the economy is not at the
         best health and that can have substantial impact on the health of the market.
      b. The trend lines of these two indexes have been in good concordance during
         the past 2 years. However, while the DJIA is trending down recently, the DJ
         transportation index seems to be still trending up. On the other hand, since
         transportation is “somewhat” a leading indicator of the health of the
         economy, the current up trend of the transportation index may indicate the
         better trend for the DJIA in the near future.


                                         Concordancy Between DJIA & DJ-Transportation Index
                                                                                              4500
                                                                                                     DJ Transportation Index Weekly Close
                                          12000




                                                                                              4000
                     DJIA Weekly Close

                                          10000




                                                                                              3500
                                                                                              3000
                                          8000




                                                                                              2500
                                          6000




                                                                                              2000




                                           01/07/2002      09/01/2003        04/25/2005


                                                             Time in Weeks




http://frontierinformaticsservice.com/Dow-Theory                                                                                   11/15/2010
Market Analysis – Dow Theory                                                                                                     Page 3




                              Concordancy Between DJIA & DJ-Trans. - 10 weeks MA




                                                                                          DJ Transportation Index Weekly Close
                                     12000




                                                                                   4000
                 DJIA Weekly Close




                                                                                   3500
                                     10000




                                                                                   3000
                                     8000




                                                                                   2500
                                     6000




                                      01/07/2002   09/01/2003        04/25/2005


                                                     Time in Weeks




                              Concordancy Between DJIA & DJ-Trans. - 24 weeks MA



                                                                                   4000
                                                                                          DJ Transportation Index Weekly Close
                                     12000
                 DJIA Weekly Close




                                                                                   3500
                                     10000




                                                                                   3000
                                     8000




                                                                                   2500
                                     6000




                                      01/07/2002   09/01/2003        04/25/2005


                                                     Time in Weeks




http://frontierinformaticsservice.com/Dow-Theory                                          11/15/2010
Market Analysis – Dow Theory                                                                                                     Page 4




                              Concordancy Between DJIA & DJ-Trans. - 40 weeks MA




                                                                                   4000
                                                                                          DJ Transportation Index Weekly Close
                                     12000




                                                                                   3500
                 DJIA Weekly Close

                                     10000




                                                                                   3000
                                     8000




                                                                                   2500
                                     6000




                                      01/07/2002   09/01/2003        04/25/2005


                                                     Time in Weeks




http://frontierinformaticsservice.com/Dow-Theory                                          11/15/2010
Market Analysis – Dow Theory                                                                  Page 5




5. Volume must confirm the trend
     a. Generally speaking, volume reflects the market’s conviction of the selling or
        buying action. A big jump in the DJIA with thin volume does mean as much
        as the same jump with large volume. Similarly, a drop of the index with heavy
        volume could be very damaging.



                                            DJIA - Weekly Close & Volume




                                                                                 5*10^9
                             12000




                                                                                 4*10^9
                             10000
         DJIA Weekly Close




                                                                                 3*10^9
                                                                                          DJIA Volume
                             8000




                                                                                 2*10^9
                             6000




                                                                                 10^9
                               01/02/2001         01/28/2003        02/22/2005


                                                    Time in Weeks




6. The trend is assumed to be in effect until definite signal shows
   otherwise.
      a. Short-term trend can be very volatile as shown in the first graph above.
         Therefore, it can send out false signal about the market direction. One should
         consider either the mid-term or long-term trend as a better indication of the
         market direction.




http://frontierinformaticsservice.com/Dow-Theory                                 11/15/2010

				
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