Wealthbuilder Stock Market Brief 16th October 2017.

Trading Dow Theory.

In the last Market Brief on the 1st October I outlined that the markets were now back on full
bull. Since then the Dow Industrials have risen 466 points. The main reason I felt confident
expressing this opinion was that while the Dow 30 had not experienced much of a pullback
since mid-May (and therefore was very much overbought) the Dow Transports had corrected
back to its 200 Daily Moving Average but was beginning to show renewed technical strength.
This indicated that the main trend, as defined by the Dow Theory system, had remained in full
force.

A number of readers have asked me to explain, in more detail, how such a correct technical
call could be made. They had come to believe that one could not trade Dow Theory. Nothing
could be further from the truth. In my experience if you can resolutely learn and apply Dow
Theory you will discover the discipline to observe market trend, find it and stick with it. With
Dow Theory will not trade often, maybe 2-3 times a year, but your trades will be super-profitable
if you stick with the trend until technical correction occurs. This takes courage. In time you will
discover that on average 7 out of 10 trades will be winners. If you progress in your trading to cut
your losses early while letting your winners run, sometimes for months or even years, you will
then have become a successful Dow Theory Trader.

This Dow Trading process was outlined brilliantly by Robert Rhea in his classic book The Dow
Theory published in 1932. Regarding trading success rate he had this to say:

The question is frequently asked, What percentage of trades, timed in accordance with a
reasonably competent interpretation of the Dow Theory, will be profitable? It is the writers
belief that any trader endowed with ordinary market sense and plenty of patience who has
studied and used the averages as a guide through the complete cycle of a bull and bear market
should be able to make at least 7 profitable turns out of every 10 efforts and each profitable trade
should net a gain in excess of the loss on a trade improperly timed. .Dow Traders do not watch
the tape but play for the important movements and are not concerned with a few points loss or
gain.

For the record, a Dow Theory Trader uses 3 main rules:

Rule1. Dow Theorys Three Market Price Movements.

There are three price movements in operation at one and the same time, in all markets. The first
and most important trend is the primary one: the broad upward or downward movements, known
as bull or bear markets. These main movements may be of several years duration. The second,
and most deceptive movement, is the secondary reaction: an important decline in a primary bull
market or a rally in a primary bear market. These reactions usually last from weeks to months.
The third, and usually unimportant, is the daily or tertiary movement (tertiary = of third rank).
Rule 2. Determine the Trend.
Successive rallies penetrating high points, with ensuing declines terminating above preceding
low points, offer a BULLISH indication.

Conversely, failure of rallies to penetrate previous high points, with ensuing declines carrying
below former low points, is BEARISH.

Analysis of such price action is crucial in appraising secondary reactions and are of major
importance in forecasting the resumption, continuation, or change of the primary trend.

A rally or a decline is defined as one or more daily movements resulting in a net reversal of
direction exceeding three per cent of the price of either average. Such movements have little
significance unless confirmed in direction by both averages, but the confirmation need not occur
on the same day.

Rule3. Wait For Both Averages To Confirm.

The movement of both the transport and industrial stocks averages should always be considered
together. The movement of one price average must be confirmed by the other before reliable
inferences may be drawn. Conclusions based upon the movement of one average, unconfirmed
by the other, are almost certain to prove misleading.

Current Practical Application.

To reiterate, the main objective with regard to Dow Theory Trading is to catch the main trend
and stick with it.

The current difficulty with this method of trading, for those folk who missed the current Trump
Rally, is how to time a market entry, at a risk reduced point. Such a point occurred on the 21st
September, as alluded to earlier, as indicated by the Dow Transport Index. This technical trigger
worked as both the Dow Transports and the Dow Industrials must confirm a Dow Theory trend.
(A trend, once signalled, continues until both indices confirm a change). The fact that the
technical weakness was neutralised on the Trannies on that date indicated to seasoned Dow
Theory traders that the current bull had gained technical re-confirmation and would, on
probability, be off to the races again. And so it came to pass.

Unfortunately Dow Theory does not tell us how long a primary market trend will last. (The
current bull is old, having commenced in March 2009) Thus while the market is extended, it still
is showing powerful Dow Theory technical strength and shows no sign of weakening but that
could change on a dime. For the record the Dow Transport index is the weaker of the two key
indices so I would anticipate that this will be the first to signal change of primary trend.

However, if you are missing this price action do not chase the market. Instead, your task
should be to wait for some degree of pull-back, on either of the averages. Once any technical
weakness diminishes (and provided the bull trend is still on) then enter a long trade and stick
with the primary trend it until it changes. If you are wrong, stop out and wait for a clearer signal.
Do not trade for random sake. This will result in trading failure. Thus the most important talents
one must develop to succeed as a Dow Theory Trader are: disciplined observation, courage to act
and stick with the trend, and patience, patience, patience.

Chart: Dow Industrials: Daily.

Chart: Dow Transports: Daily.

Charts: Courtesy of StockCharts.Com

Source: The Dow Theory by Robert Rhea, Faber Publishing Company.

Christopher M. Quigley, 16th October 2017