There are 3 assumptions made in Dow Theory which are also the assumptions of all technical analysis.If one of these assumptions does not hold in reality, then technical analysis will have no function.
1 The Market Discounts Everything
All the technical theories view price as a product of all information and factors in market. Why it says so? Any news, economic factors, fundamental factors or even insider’s news have already reflected in stock price because everyone will buy and sell stock based on information he knows. For example, insider will buy stock based on news which is non-public. This will cause the stock price to move. This incident shows that although the news is not known by public, it is already reflected in the stock price. As a result, the price has absolutely reflected market sentiments at any given time. Thus, market action is the most solid and unarguable. As a result, you know why Price and Volume are the only things matter in any of the technical analysis.
2 Price Moves in Trends
Dow invented the term bull market and bear market. In bull market, most of the stock prices go upwards. In bear market, most of the stock prices go downwards. Once a price’s trend is established, it tend to run its full course. This is because price movement will trigger and reinforce human’s expectation and emotion. In an uptrend, the price movement will trigger humans greedy and further reinforce their expectation. This happens in the same way to a down trend. That is the reason why price always moves in trend. If price does not move in trends, then there is no use to do technical analysis, because it means movement of price is random and there is no way to predict the movement of share price.
3 History Tends To Repeat Itself
This idea is applied in term of price movement. What has happened in the past will happen again, and again, and again. The repetitive behaviour of price movement is attributed to market psychology. People basically acted and react to the market scenario based on emotion. How this could happen? This is because human emotion had solidly built into human nature, which always gets in the way of human intelligence and hardly be changed. If history does not repeat, there will be no use to study history price and technical analysis once can be used in the past will not function in the future. Remember, human will change but human nature will not. There are always greedy and fear where the investment take place.
Only one thing I would like to share about Dow Theory. Others I will include in Wave Theory.
After Dow propose the concept of Bull Market and Bear Market, he also defines that Bull market and Bear market each has three phase.
We will focus more on the bull market. Why? Because we only trade in Bull Market. The best strategy in Bear Market is selling out all the stock and go far far away.
Bull Market
First Phase
Condition
- Stock Market Index in the lowest point but not dropping.Most company profits not increase but remain constant.
- PE at the lowest point.
- Price of certain blue chip stocks start to move upward slowly.
Psychology Behind
- Most retails already leave stock market causes stock market very inactive
- Intelligent investors start to accumulate certain blue chip stocks with low price.
Strategy
- Search for certain blue chips where their price already move.
- The safest time to use full leverage since price already at the lowest.
Second Phase
Condition
- Stock Market Index start to move.
- Blue Chip company profits increase.
- PE of Blue Chip starts increase.
- Price of most good Blue Chip increases fast.
- In the late second phase when the Blue Chip PE is high enough, 2nd and 3rd line stock price with good financial result will go upwards.
Psychology Behind
- Profit of company increases attract long term investors to buy in and push up the price.
- Most investors think that the crisis already pass.
- When Blue Chip is expensive enough, 2nd and 3rd line stock with good financial result becomes more attractive to investors due to cheaper price.
Strategy
- Focus on Blue Chip and later 2nd and 3rd line stock with good financial result
- 100% cash in stocks but less leverage.
Third Phase
Condition
- Stock Market Index at new high but constant.
- Company profits still increase but not as fast as increase of price.
- PE becomes very high and unreasonable.
- Penny Stocks rally.
- Trading Volume at new high.
- Usually Central Bank start to increase interest rate.
Psychology Behind
- Retails back to market attracted by the stock market index.
- Retails more interest in penny stocks cause it to rally.
- Retails trade frequently and even with margin and limit.
- Long term investors start to leave the market.
- To prevent bubble of stock market become larger, Central Bank increases interest rate.
Strategy
- Focus on penny stock based on the themes
- Maximum 50% cash in stock
Bear Market
First Phase
Condition
- The whole stock market start to drop gradually.
- The profit of company remain constant and start to decline.
- The number of stocks dropping is more than the number of stock rising.
- Hardly find and good company with cheap price.
Psychology Behind
- Institution investors selling their stocks to Retails. In order not to surprise the Retails, this process going slowly.
- Retails blinded with greedy think that this is only a correction and hope stock market will go higher.
Strategy
- Run away
Second Phase
Condition
- Stock market drop instantly and continuously.
- Profit of company decrease.
Psychology behind
- Institution investors throw out their last stock instantly cause the stock market to crash.
- The situation becomes worse caused by the panic sell of the Retails.
Strategy
- Don’t go inside
Third Phase
Condition
- Dropping of stock market start to slow down.
- Company attains negative profit.
Psychology behind
- Retails despair and sell out all their stocks.
- No investors willing to go into the market.
Strategy
- Go doing other things.
Continue to Step 3: "Elliott Wave Theory"
Return to "Library Index"
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