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Purpose of the Dow Theory
The purpose of the Dow Theory is to determine the market's primary trend. Successful investing, according to the Dow Theory, means staying on the right side of the primary trend and ignoring short-term movements.
A bullish indication under the Dow Theory occurs when rallies in both the Dow Industrials and Transports penetrate significant high points, with ensuing declines terminating above preceding low points. In other words, a bull market, according to the Dow Theory, means that both the Dow Industrials and Transports have moved to new highs. Conversely, if, after a secondary market correction, both the Industrials and Transports fail to move to new highs and instead fall to levels below the significant lows reached during the secondary correction, a bear market is signaled. The difficulty, of course, is knowing which points represent "significant" highs or lows. That is where an understanding of secondary reactions is useful.
Secondary Reactions
Perhaps the most difficult aspect of using the Dow Theory is deciding whether a market pullback is the beginning of a bear market or just a correction within an ongoing bull market. Likewise, a rally during a bear market is often misconstrued as the beginning of a new bull market. In evaluating secondary reactions, keep in mind the following points:
Secondary reactions usually last three weeks to three months.
Secondary reactions tend to retrace one-third to two-thirds of the previous primary market move.
Secondary reactions tend to be more violent and sharp than the underlying primary trend.
By keeping these factors in mind when evaluating intermediate-term market movements, you should avoid buying or selling stocks prematurely.
Strength of the Dow Theory
One reason the Dow Theory has stood the test of time is that it avoids the frequent "whipsawing" that occurs with many timing models. Dow Theory signals are long term in nature, usually lasting one year or longer. For..
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