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luck) unless you know the direction of the trend and how to identify a change of trend. While Dow Theory is still fresh on your mind, there are some additional observations from it that can be extremely useful. A few of these observations apply only to the equities markets, but most of them apply to any market. Understanding them is of tremendous help in identifying when a change of trend is likely to occur or has already occurred.


In trading the equities markets, one of the biggest mistakes anyone can make is to draw conclusions

based on the movement of just one market average. It is not infrequent for one average to reverse

direction for a period of weeks or even months, while another average keeps moving in the opposite

direction. This is called a divergence and is useful only in a negative sense. As Rhea put it:

Both Averages Must Confirm:-The movements of both the railroad and industrial stock averages

should always be considered together. The movement of one price average must be confirmed by

the other before reliable inferences my be drawn. Conclusions based upon the movement of one

average, unconfirmed by the other, are almost certain to prove misleading. Rhea made this observation in 1932. In addition to the Industrial and Railroad (Transportation) indexes, we now have the S&P 500, the Value Line, the Major Market Index, bond indexes, dollar indexes, commodity indexes, and so on. Therefore, bringing this principle up to date implies that instead of "both averages must confirm," the principle should now be "all related averages must confirm." A good example of how this principle must be applied occurred in the period following the October 1987 crash.

First of all, you will recall that one of the "theorems" of Dow Theory is "The theory is not infallible." This was borne out through the crash. Based on Dow Theory, I thought that the era sh of October 1987 was the second downleg of a bear market. All related averages went to new lows that broke below previous important lows-a Dow Theory indication of a bear market. But we never entered one. Even so, by a strict Dow Theory reading after the fact, the period following October 19th, 1987, was a secondary correction in a primary bull market, the only one in 91 years that broke below previous secondary lows jointly without leading to a bear market.

It has to be classified as a correction because it did not meet the criterion as defined by Rhea in the definition of a primary bear market. My contention is that if the Fed had not eased in October, and if the Germans and Japanese had not stimulated their economies in December with an infusion of easy credit, a needed bear market would have ensued to correct the malinvestments of previous years. But they did intervene, the S&P bottomed in December, and eventually the market went to new highs. This is where the principle that "all related averages must confirm came into play.

First, on April 18, 1989, the Transports broke highs established in August 1987. The Value Line followed on July 10th, followed by the S&P 500 index on July 24 (but only 29% of the group indices within the S&Ps went to new highs in 1989). But by a strict Dow Theory reading, the confirmation date didnt occur until April 18, when the Industrials average broke through the August 1987 highs and continued to climb (Figure 5.5). Now, I classify the period from August 25,1987, through t December 4, 1987, as a secondary correction in a primary bull market for the Transports, whereas August 25,1987, to October 19, 1987, is the correction for the Industrials. It was a confusing time, and without the objectivity of Dow Theory to guide me, it would have been even more confusing.

I should point out that, despite the freak nature (in the context of history) of the 1987 market, a rigorous Dow Theory reading gave a clear intermediate sell signal on October 14 when the Dow Industrials broke below the September 21 lows on accelerating volume (the Transports had already made a new low). It didnt matter whether you classified the long term trend as a bull or a bear. But if you considered

Dow Jones Industrials Monthly Bar Chart

2500 -

2000 -

1500 -

1000 -

1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990

TQ 20/20 1991 CQG Inc.

Figure 5.5 The Dow Industrials Weekly Bar

Chart-confirmation of a continuing bull market. The

confirmation that the bull market was still in progress

occurred on April 18,1989, when the Industrials average

broke through the August 1987 highs and continued to


the crash the second leg of a bear move, there were no clear long-term buy signals after that.

Assuming a bear market, I went long on October 24,1987, looking for a secondary correction. After closing my long position in March 1988, I wasnt significantly involved until early October 1989, at which point I did as described in Chapter 2. Dow Theory was a major contributor to my October 13,1989, call.


Two of the key indicators Im referring to as "signals" are the formation of lines and volume relationships. A market is always in one of four technical phases: (1) It is being accumulated (bought by long-term investors), (2) It is being distributed (sold by long-term investors), (3) It is trending up or down, or (4) It is consolidating (adjusting after profit taking in a confirmed trend). Another way to put this is that if a market isnt in a trend, then it is drawing a line. Rhea defined a line as follows:

Lines:-A "line" is a price movement extending two to three weeks or longer, during which period the price variation of both averages moves within a range of approximately 5%. Such a movement indicates either accumulation or distribution. Simultaneous ad

vances above the limits of the "line" indicate accumulation and predict higher prices; conversely, simultaneous declines below the "line" imply distribution, and lower prices are sure to follow.

Conclusions drawn trom the movement ot one average, not confirmed by the other, generally prove to be incorrect.

When lines occur, it is usually at intermediate market tops and bottoms, in which case Rheas definition applies well. At major market tops, prudent long-term investors with superior information try to se off their (very large) portfolios over a period of time without creating significant downward pressure on prices. Because there is still enough speculative bullish interest, they manage to distribute their stocks m relatively small lots to traders and speculators. As a result, prices fluctuate up and down without trending up or down over a period of several weeks or more forming a "line." This may also happen on any particular stock and in the commodity markets.

When there is finally a predominance of pinion that prices are going to go down, the line is broken on the downside. In trading terms, this is called "a break"an excellent opportunity to sell short in stocks or commodities (See Figure 5.6).

At major market bottoms, the same thing often happens, but in reverse. Prudent longterm investors see value after price declines and build up large positions for their portfolios to hold over the long-term. Whether to test the market, or to avoid putting upward pressure on prices, they build their positions quietly over a period of several weeks to months. The result again is the formation of a line. When there

May 1990 Sugar Futures Daily Bar Chart




Price Break


f! !



TQ 20/20 (~ 1991 CQG Inc. Figure 5.6 May Sugar Futures-a price break, usually a good sell signal.

is finally a predominance of opinion that prices are going up, the line is broken on the up side. In trading terms, this is known as a "breakout"-an excellent buying opportunity in stocks or commodities (see Figure 5.7).

An interesting aspect of looking for breaks or breakouts is that it is the only time when watching the day to day trend of prices is important to every market participant, whether trader, speculator, or investor. As Rhea put it:

Daily Fluctuations:-Inferences drawn from one days movement of the averages are almost certain to

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