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ASX Investor Update
March 2017
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Dow Theory and the current bull market

The March 2017 edition of the ASX Investor Update newsletter features an article
from Robert Brain about Dow Theory and the current bull market

Every chart tells a story - it pays to understand the stories in the price charts!

Included below is more information, and larger versions of the charts
with a special offer for Investor Update readers.

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The March 2017 ASX Investor Update newsletter

Robert's contribution to the March 2017 ASX Investor Update newsletter included many more words than could be accommodated in the published version of the newsletter. The full article with additional comments and larger versions of the price charts is included here (Toolbox Members click on the images for a larger version).
 
See the published article at the ASX website, and also see the full edition of this ASX newslettter.


Bulls versus Bears: What Dow Theory tells us

Where the sharemarket is now and what may bring a change.

According to Dow Theory there are reputed to be three stages to a bull market, so which stage are we currently in? And what might happen next?

Many people have heard of “Dow Theory”, but are often puzzled by it. In this article we explain some key aspects of Dow Theory in relation to bull markets, and this might challenge your current thinking about your investing in the markets and encourage you to think a little differently about it.

Also, when working through this material it is useful to understand that the ideas and terminology explained here with reference to the Australian All Ordinaries index (XAO), but are equally applicable to overseas indexes (such as the Dow Jones Industrial Average index, S&P500, Russell 2000 and many others), and also to individual stocks.

What is Dow Theory?

Firstly, the term Dow Theory refers to a body of knowledge which underpins key aspects of contemporary technical analysis. It is not a methodology for 100 percent guaranteed success in the markets; but it is extremely useful because the price charts of various financial instruments summarise the opinions of the market participants.

Knowing something about the basics of Dow Theory will help with understanding the underlying mood and sentiment of the market participants, to help give you an edge. There are six key tenets of Dow Theory, and today we will focus on just a couple.

Tenet #4 — “A trend remains in effect until a clear reversal”

To help set some foundation understanding, let’s skip the first three tenets of Dow Theory and talk briefly about share price trends — uptrends and downtrends. In technical analysis terms a trend is defined on the price chart as a sequence of higher peaks and higher troughs for a bull market period (an uptrend), and a sequence of lower peaks and lower troughs for a bear market period (a downtrend).

In the first chart here (a weekly chart of the XAO index), note the sequence of higher peaks (labelled P1, P2, P3, etc.) and higher troughs (labelled T1, T2, T3, etc.). These higher peaks and troughs indicate an uptrend from early 2003 until mid-2007. The lower trough T7 indicates the uptrend had finished (because it is lower than the trough before).


Dow Theory and trends (weekly line chart)
Trends - the basics
(Toolbox Members click on the chart for a larger image)

We also note there are lots more peaks and troughs on this chart, situated in between the ones that are labelled. These indicate the shorter term noise, and in fact can also be used to indicate a price trend in shorter time frames. For instance, between peak P2 and trough T3 there are several lower peaks and lower troughs which indicate a downtrend within this shorter time frame. Likewise between P4 and T5 (and also between other peaks and troughs).

The important point here is that over the period from 2003 to 2007, the index was in a major uptrend. And in fact, the straight, dashed green lines on either side of the price action indicate the boundaries of the price action on this weekly chart, and are what we refer to as a “Trend Channel”. Also, if you have trouble putting a trend channel like this onto your chart of the index, try giving the vertical axis a log scale — not linear. We discussed this in the October 2015 ASX Investor Update article about the resources sector.

Another Dow Theory tenet, “a trend remains in effect until a clear reversal”, suggests that once an uptrend is in place, it is considered to be in place until we no longer have a higher peak and a higher trough (and conversely for a downtrend). When identifying these on the price chart, we sometimes have to ignore the noise of the intermediate swings (peaks and troughs), within the bigger-picture trend. This is the challenge of identifying the different trends in the different time periods. [This advanced topic of trends in different time frames is discussed here for Toolbox Members.]

As it happens, once a trend is in place and confirmed, it is likely to continue until it is confirmed to have finished. That means that if a downtrend is confirmed for a particular stock, then the downtrend is likely to continue, and we should not be entering a position until the downtrend is confirmed to have finished.

By the way — We can also place a straight “trend line” under the price action on a chart, touching the troughs of the uptrend, and which appears to support the rising prices. There are several uses for a trend line. See more information about trends in the Toolbox.

Tenet #2 — “The market has three main movements” 

This statement is another of the six tenets of Dow Theory. The first of the three main movements to which this refers, is regarding the longer term bull or bear markets which can last from one year up to several years. In the first price chart above we can clearly see a bull market in the first three quarters of the chart which lasted for about five years, and a bear market in the last quarter of the chart which lasted for about 16 months. So a bull market and a bear market are the first of the three different types of main movements. They can also be referred to as a primary movement or primary uptrend (or downtrend).

The second of the three main movements is the medium term move where the price retraces (also referred to as a secondary reaction). It can last from about 10 days up to several months. And we can see many of those in the price chart above — both downward moves within the bull market, and upward moves within the bear market. So, technically, the move P2 to T3 is a secondary reaction (lasting about 8 weeks) which suggests that the move from T1 to P2 is one primary bull market, ending at the peak P2.

The third main movement is a reference to the very short term noise and can last from just a few hours to many days. It is more apparent on a daily price chart (not the weekly chart above). The average retail investor should not focus too much on the market noise, while the short term traders take advantage of these market swings back and forth in these short time periods. 

Tenet#3 — “Primary movements have three phases” 

Now that we have looked at our market in recent years, and identified some primary market movements (especially the uptrends), we can consider this next tenet of Dow Theory. The three phases within the primary movements are considered to be: (a) accumulation phase, (b) public participation phase, and (c) excess phase.

It is actually a little difficult to spot these three phases for many of the primary uptrends considered above — unless we also look at the volume. So the next chart shows the last two year period from February 2015 until 17th February 2017. It is a weekly chart again, but also shows the weekly volume in the bottom pane.
 

Trends are confirmed in volume (weekly chart)
Trends are confirmed with volume
(Toolbox Members click on the chart for a larger image)

In this chart, note what happened the last time a bull market uptrend ended in April 2015 (the left end of this chart, before falling 19 percent from P17 to T19). The index tried to move higher but could not push above about 5960. For several consecutive weeks in March and April the volumes decreased week on week (indicated in this chart). These declining volumes indicated less and less interest in purchasing stocks (ie. declining demand), and eventually resulted in the index commencing a fall in late April. This is what happens when the demand dries up, leaving a lot more willing sellers compared to the dwindling numbers of buyers.

This is actually the sixth tenet of Dow Theory — “volume provides additional evidence”.

Also on this topic, note the rising index just after trough T19, and also note the volume bars. The index rallied higher in a clear uptrend to peak P19. The first few volume bars starting at T19 and immediately after T19 are all higher than the preceding volume bars. This indicates support for the higher prices (the higher value of the index - but remember that retail investors don't trade in the index, because they are trading in shares in companies that might make up the index, and it is the volume in these shares which is indicated here).

That’s some of the theory, so now let’s look at the practical aspects — and consider the question: Where are we now?

Where are we now? — which bull market stage?

Let’s start by looking at the quarterly chart of the index below (a quarterly chart shows the index value at the end of each calendar quarter regardless of what happened during the quarter — but a candlestick chart will show the range in price). We can easily spot the bear market bottom in March 2009 (T12). This is followed by what might initially look like a sequence of higher peaks and troughs — except that, technically, it is not (because T14 is lower than T13, and T18 is lower than T17), even though the index was low in March 2009, and is much higher towards the right end of this chart. Some people might suggest at a glance that we have an uptrend on this chart because the price is low near the left end of the chart, and it is higher at the right end.
 

The latest bull market (XAO — Quarterly chart)
The latest bull market (XAO — Quarterly chart)
(Toolbox Members click on the chart for a larger image)

There are actually several periods on this chart that are primary (bull market) uptrends (from T12 to P12, and T15 to P17, and T18 to P19). Each of these have secondary reactions between them. So what is likely to unfold in the coming weeks?


If we drill down and look at the weekly or daily chart for the same period, any conclusions should be clearer. So let’s look at the following daily chart.


The latest bull market
The latest bull market (XAO — Daily chart)
(Toolbox Members click on the chart for a larger image)

Firstly, notice at the right end of the chart that daily volumes increased through January 2017 and into February while the index fell by only 3 percent. This suggests an excess of sellers (which is bearish).

For the current bull market uptrend to be confirmed, we need to see the index push higher than the earlier peak P17 (a potential resistance level off the left edge of this chart, but the level is indicated with the horizontal, dashed red line). Perhaps we need to see the end of the current February reporting season to weigh up whether this is likely [this material was written on 23rd February]. And if it does happen, we ought to see the index continue to “trend” higher (higher peaks and troughs), and with increasing volume to indicate the increasing interest in participating in the market. If the volumes decline while the index rises, it will indicate a lack of interest and a lack of support for the higher prices.

Depending on the final outcomes of the February reporting season, we might see enough positive results and earnings forecasts to encourage investors to rush into the market. If this happens, we might then see irrational exuberance — a sign of the final “excess” phase of a bull market. And if Wall Street starts to think that Donald Trump won’t be as successful as everyone had thought in stoking the US economy, then we could see the bull market here in Australia, and in the US, come to an end.

So, keep an eye out for higher peaks and troughs, and for increasing volume on the upward legs.



Also note one key aspect of the above discussion. We started by looking at the big picture — a longer time period on a monthly chart (because the share market is like an elephant). Then we drilled down to a weekly chart and shorter time period, and finally a daily chart as well as the candlesticks to better understand the daily movements in the market.

More Information?

Do refer to the online article at ASX.com.au for the published version of this article.

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