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Figure 4.1 The Daily Bar Chart of the Dow Industrial and Transportation Average, with volume included.

primary trend: the broad upward or downward movements know as bull or bear markets, which 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 b ear market. These reactions usually last from three weeks to as many months. The third, and usually unimportant, movement is the daily fluctuation. °

While basically accurate in Rheas terms, Dows three movements apply not only to the averages, but to any market. An easy to remember reformulation of Rheas first theorem is:

There are three trends in the stock averages and in any market: the short-term trend, lasting from days to weeks; the intermediate-term trend, lasting from weeks to months; and the long-term trend, lasting from months to years. All three trends are active all the time and may be moving in opposing directions.

The long-term trend is by far the most important trend and the easiest to identify, classify, and understand. It is of primary concern to the investor and, to a lesser extent, the speculator. The intermediate- and short-term trends are subsidiary components of the longterm trend and can only be understood and fully taken advantage of through a recognition of their status within t he long-term.

The intermediate-term trend is of secondary importance to the investor and of primary importance to the speculator. It can move with the long-term trend or against it. If the intermediate-term trend significantly retraces the long-term trend, it is characterized as a secondary reaction or a correction. The characteristics of a secondary reaction must be closely evaluated to avoid confusing it with a change in the long-term trend.

The short-term trend is the least predictable and is of primary concern only to the trader. The speculators and investors interest in the short-term trend should consist almost solely in optimizing profits and minimizing losses by timing of buys and sells within the shortterm movement.

Classifying price movements in terms of the three trends isnt just a mental exercise. The investor who is aware of the three trends focuses on the long-term trend, but depending on how hard he wants to work, he can use intermediate- and short-term movements that run contrary to the primary trend to optimize profits in several ways. First, if the long-term trend is up, he may choose to profit from a secondary reaction by selling stock short throughout the correction and then using the profits to pyramid his long position somewhere near the turning point of the correction. Second, he may do the same thing by buying puts or selling calls. Third, he may ride through the contra-move with confidence, knowing that it is an intermediate-, not a long-term, move. And finally, he may use short-term movements to time buys and sells for optimum profitability.

For the speculator, the same kind of thinking applies, except that he is not interested in holding positions through secondary reactions that move against him; his object is to move with the intermediate-term trend in either direction. The speculator can use the short-term trend to look for signs that the intermediate-term trend is changing. The mind set is different from that of the investor, but the basic principles used to identify change are very similar.

Since the early eighties, program trading and improvements in the dissemination of information have dramatically increased the volatility of intermediate market movements. Since 1987, daily fluctuations of 50 or more points in a day have become commonplace. Because of this, I think the wisdom of the long-term "buy and hold" approach to investment is now questionable at best. To me, it seems self-evident that it is a waste to hold long positions through corrections, watching as years of gains are whittled down to almost nothing. True enough, in most cases those gains will come back over a period of months to years. But if you focus on the intermediate -term trend, the bulk of these large losses are avoidable. I therefore think the main focus of the prudent investor should be on the intermediate-term trend.

But to accurately focus on the intermediate-term trend, you have to understand it in relation to the long-term, or primary trend.

Theorem number 2:

Primary Movements: The primary movement is the broad basic trend generally known

as a bull or bear markets extending over periods which have varied from less than a year to several years. The correct determination of the direction of this movement is the most important factor in successful speculatio n. There is no known method of forecasting the extent or duration of a primary movement. [Emphasis added]

Knowing the long-term trend, or primary movement, is the essential minimum requirement for successful speculation and investment. The speculator who knows and is confident of the long-term trend has enough knowledge to make a decent living, given at least minimum prudence in timing specific market selections. Although there is in fact no way to predict with certainty the extent (how big) or duration (how long) of a primary movement, it is possible to characterize primary movements and secondary reactions statistically using historical price movements as a data base.

Rhea characterized all price movements in Dow history as to type, extent, and duration b ut had only about three decades of data to work with. Remarkably, there is little difference between the characterizations he made then, and those made now with 92 years of data.6 For example, the bell curve distributions of both the extents and durations of secondary reactions in both bull and bear markets, classified jointly or separately, is virtually the same now as it was when Rhea published his data in 1932; there are just more data points now.

This is truly remarkable because it tells us that, with a the sophistication and knowledge gained in the last half century, it is obvious that the psychology which drives market price movements is very similar over time. What this means to the professional speculator is that it is highly probable that market movements will fall within a limited range of their historical extent and duration medians. If a price movement extends beyond its median levels, then the statistical risk of being involved in that trend grows each day. If carefully weighed and applied, thi s dimension of risk assessment can add significantly to the probability of accurately forecasting the future of price movements.

Theorem number 3:

Primary Bear Markets: A primary bear market is the long downward movement interrupted by important rallies. It is caused by various economic ills and does not terminate until stock prices have thoroughly discounted the worst that is apt to occur. There are three principal phases of a bear market: the first represents the abandonment of hopes upon which stocks were purchased at inflated prices; the second reflects selling due to decreased business and earnings, and the third is caused by distress selling of sound securities, regardless of their value, by those who must find a cash market for a least a portion of their assets.

Several aspects of this definition need to be clarified. The distinguishing characteristic of the bear market movement is that the "important rallies," or secondary corrections, in both the Industrials and the Transports never penetrate the previous bull market top or previous intermediate highs jointly. The "economic ills" referred to are, almost without fail, the result of govemment action: interventionist legislation, grossly restrictive tax and trade policies, irresponsible monetary and/ or fiscal policy, and major wars. 8

Based on my own Dow Theory classification of the market averages from 1896 to the present, some of the key characteristics of bear markets are as follows:

1. The median extent of bear markets is a 29.4% decline from th e previous bull market high, with 75% of all bear markets declining between 20.4% and 47.1%.

2. The median duration of bear markets is 1.1 years, with 75% of all bear markets lasting between 0.8 and 2.8 years.

3. The beginnings of bear markets usually follow a "test" of the previous bull market high.on low volume followed by sharp declines on high volume. A "test" is when price levels closely approach but never reach the previous high point jointly. The low volume during this "test" is a key indication that confidence is at a low ebb and can easily tum into an "abandonment of hopes upon which stocks were purchased at inflated prices" (see Figure 4.2).

4. After an extended bear swing, secondary reactions are usually marked by sudden and rapid advances followed by decreasing activity and the formation of a "line," which ultimately leads to