|To lay the ground work for using the Dow Theory there are a few basic elements that we must consider. First, Charles Dow did not use daily prices much in his analysis; he used weekly prices. He equated daily prices to ripples in the ocean and insignificant. He further equated weekly closing prices to the ocean waves and the monthly closing price to the ocean tide, both of which he considered to be important. Having said that, to be clear, there were times when Charles Dow did consider daily closing prices. Second, Charles Dow considered the closing prices to be the most important over the open, high, or low prices and used them in his analysis. Finally, Charles Dow considered a bull market to be a series of rallies lasting at least two years.|
|FIGURE 1: CAT, WEEKLY. This chart shows the weekly closing price of Caterpillar, stock symbol CAT. Chart also shows the expected path Caterpillar might take as its primary bear market unfolds over the next several years.|
|Graphic provided by: MetaStock.|
|The chart in Figure 1 is a line chart of the weekly closing prices of Caterpillar (CAT). This chart shows a series of rallies starting March 6, 2009 and ending February 24, 2012 lasting more than two years qualifying it as a bull market trend.|
The first thing we must realize in analyzing a bull market trend is that Charles Dow identified a trend as having three rallies separated by two secondary reactions. I have identified two secondary reactions separating three rallies by the two green ovals on the chart. Charles Dow further identified a secondary reaction as a retracement of approximately 33% to 66% of the rally directly preceding it. Note that the first secondary reaction was a 55% retracement of the preceding rally and the final secondary reaction was a 49% reaction to the rally beginning July 10, 2009 (the end of the first secondary reaction).
|Two other minor reactions are noted between the first and second secondary reactions. There are two reasons why these two reactions failed to be identified as secondary reactions. First is that their reactions were less than 33% of their respective immediate preceding rallies. Second, Charles Dow identified a bull market as a trend that lasted on average 25 months. These two intermediate reactions occurred approximately 12 months after the beginning of the bull market trend or half the average time frame for a bull market. For these two reasons these reactions were discounted as valid secondary reactions.|
|Once a second secondary reaction was completed, Charles Dow identified that price would make one more rally to a new higher high before the trend came to an end. CAT started its final rally on September 30, 2011 and ended February 24, 2012. Note that after making a final high in February of 2012 CAT traded for another 18 months without making a new higher high. Thus the bull market trend in CAT ended in February of 2012. So how do we label the following 18 months starting February 24, 2012 knowing that during this time CAT has lost 25% of its value? With CAT having lost 25% of its value since February 24, 2012 it seems that this time frame should be considered a bear market. To answer this question we must look at how Charles Dow classified a Bbar market trend.|
|Charles Dow identified a bear market trend as also having three downward movements interrupted by two important rallies or secondary reactions. Therefore, if we consider that the primary bull market in CAT as having ended on February 24, 2012 then we can also consider that a new primary bear market as having begun. Therefore the downward movement from February 24, 2012 ending on July 20, 2012 is identified as the first of three downward movements in a new primary bear market. Further, the rally from July 20,2012 ending February 1, 2013 is considered the first of two secondary reactions as it has retraced 58% of the first downward movement of the new bear market (see red oval on chart in Figure 1). If this analysis is correct, then the period of time that has elapsed since February 1, 2013 represents the beginning of the second of three downward movements in a primary bear market trend of CAT. I have added a blue zigzag line at the end of the chart to show how CAT might proceed during the balance of its expected primary bear market.|
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