DOW Theory

There is an old argument that says the best share trading strategy is to 'buy and hold' and that the use of any market-timing tool is a waste of time. Those holding Telstra shares from the second tranche or those who bought into Newscorp at its soaring heights or indeed, AMP Limited before its disaster of 2003 may beg to disagree. The Dow Theory prescribes to the broader market, not to any individual company.

There is always value in knowing whether the market's primary trend is bullish or bearish. In a balanced widely spread portfolio, the Dow Theory is a tool that can preserve capital as it can assist in keeping investors on the right side of the primary trend.

One of the main reasons the Dow Theory has supposedly stood the test of time is that it avoids the frequent "whipsawing" that occurs with other market-timing models. In theory, investors who prescribe solely to the Basic tenet of the Dow Theory will ride with a long-term bull market and hence avoid trading out of stocks during that time. As we all know, missing the major turns in a market can lead to loss of capital or at the least, missing out on maximising share market returns.

When using the Dow Theory, it is important to realise that the Theory does not project how high or low primary market trends will carry. The goal of the theory is to determine changes in the major trends or movements of the market. It simply points out a trend. Also, by the time the Theory has signalled that a change in the primary trend has taken place, the market could already be well off its bull-market high or bear-market low. Still, while the Theory is unlikely to get an investor in at the exact top or bottom of the market - no timing tool can make this guarantee - it is generally seen as an aid to investors/traders.

The theory states that the market has discernable cycles. The hypothesis is predicated on the idea that each cycle lasts between two to ten years, and within the cycle there are primary, secondary and minor trends.

The three trends are:

1. Uptrend: three successive higher peaks (highs) and three higher troughs (lows)
2. Downtrend: three successive lower peaks and three lower troughs
3. Sideways: peaks and troughs don't successively rise or fall

The Dow Theory runs on the premise that the end-of-day market prices reflect every significant factor that affects supply and demand, volume of trade, fluctuations in exchange rates, commodity prices, interest rates, and so on. In other words, the closing price is a combined judgement of all market participants.

To the equity investor/trader and the option and CFD traders, it is these secondary or minor short-term trends that are of interest. They overlay their technical and fundamental knowledge along with their market knowledge on top of the Dow Theory to judge the extent and strength of the short-term moves, and when to exit the likes of Telstra, AMP or other under-performing companies.