to occur over the next few days or even months. But what is that based on? Price reflects the market’s level of supply and demand, and may have no relevance whatsoever to value itself. For example, if a large mutual fund decides to sell off its holdings of a company, thousands of shares are dumped on the market. That will cause a price decline because, unex- pectedly, there is a large excess supply of shares. In the opposite scenario, that big mutual fund may decide to acquire a large block of shares, creat- ing less supply. The basic economic reality kicks in at that point: more supply causes a decline in price, and less supply causes an increase in price. But now consider the underlying reality: The decision by an insti- tutional investor (like a mutual fund) to buy or to sell a large number of shares of a company may have little or nothing to do with that com- pany’s fundamental strength or weakness. The decision may be a matter of portfolio balance, investment objective, or other reason that is not based on profit and loss or capitalization of the company.
A realistic combination of fundamental and technical analysis should be undertaken with the full realization that the two methods are not merely aspects of the same process. They are entirely separate and based on dissimilar assumptions. The fundamental approach relies on fi- nancial results and status; the technical approach is price-based.
more explanatory reasons for downward trends—
that is, consolidation, profit-taking, and the like.
The DJIA is interesting to fundamental in- vestors as a reflection of the Dow Theory, because the same principles underlying this theory can be applied on the fundamental side as well. Charles Dow was cofounder (along with partner Edward C.
Jones) of the Dow Jones Corporation and of the publication that came to be known as the Wall Street Journal. During his lifetime, Dow published a series of essays in which he developed ideas for tracking corporate trends as well as stock prices. He
believed in the principles of testing information by way of confirmation and breaking trends into three types: primary, secondary, and daily.
While Dow himself did not solidify these theories into a distinct theory concerning the market, his ideas were applied after his death, and the Dow Theory came into being. First articulated by an associate of Dow’s, Samuel Nelson, who published a book called The ABCs of Stock Specula- tion, the concept has since been further developed by Dow’s successor as editor of the Wall Street Journal, Peter Hamilton.
The Dow Theory as practiced today is a technical indicator; but it is valuable to tracking market trends over the long term, and can also be applied to the study of fundamental information. The concept of devel- oping and tracking financial trends makes as much sense as it does for prices. Businesses depend on budgets and forecasts and unending finan- cial analysis as part of monitoring profits. Business managers look for im- portant indicators in order to take action quickly. For example, in an expense budget, if a month’s expenses exceed the budget, management will want to know why. Steps need to be identified to stop a negative trend and bring expenses in line with the budget.
Market observers also look for pricing signals through the Dow Theory. A new trend is believed to be established when three specific
T h e D o w T h e o r y 43
valuable resource for more informa- tion about the DJIA, component stocks, weighting, and other links, check the Dow Jones website at http://averages.
dowjones.com.
Although the Dow Theory is used today to track market price trends, its principles can also be effectively applied to fundamental analysis.
Key Point
events take place. In a bull market, these events are the purchase of low-priced stocks when the market mood is negative; earnings growth in companies whose stock prices are low; and the discovery by the market as a whole of the value in stocks, which leads to greater demand. In a bear market, the three events are the sale of high-priced stocks by better- informed investors; a dwindling supply of willing buyers at current prices; and acceleration in the sale of shares, causing further price declines.
Most people recognize these generalized trend observations as contrarian investing standards, the tendency among better-informed investors to make decisions in directions opposite that of the broader market.
In addition to the three-part definition of contrarian tendencies among investors as a means for identifying a trend, the Dow Theory also re- quires confirmation. This is a process of checking one indicator against another. According to the Dow Theory, a new trend is established only if and when the Dow Jones Transportation Average fol- lows the DJIA in moving away from its previous level; and the new trend stays in effect until both of these indices have reversed direction. In this sense, the transportation average confirms the DJIA.
The Dow Theory has become institutional- ized as the major indicator of the market—even with equal news coverage given to the S&P 500 and the NASDAQ indices—that most people consider the point change in the DJIA as representing the entire market. However, as interesting as the indices are in tracking markets, the theories first put forth by Charles Dow have strong and specific applications in fundamental analysis.
Just as stock prices can be tracked, confirmed, and broken out into primary or secondary movements, so can financial data. The very nature of trend analysis and the use of ratios expressed as part of moving aver- ages, forms an intelligent system for grasping the importance of financial trends over time—and for quantifying those trends as very significant or temporary in nature. Because most people follow more than one funda- mental indicator (or use combinations of fundamental and technical
contrarian investing a tendency among better-informed investors to anticipate coming trends and to trade accordingly—
buying bargain- priced stocks when others are selling, and selling overpriced stocks when others con- tinue to buy.
confirmation the principle that a second indicator must move in the same direction as the primary indi- cator to establish a new trend; and that both indica- tors need to re- verse direction before another change in trend is identified.
data), confirmation is a natural process and it adds value. If one indicator implies a change in direction in earnings, for example, one way to verify the information is to check other indicators to see whether an expected shift is occurring there as well. Looking at indicators in isolation can be misleading; but when two or more different indicators tell you the same thing, that is very strong evidence.