Mr. Dow, Mr. Jones, And The Genesis Of Dow Theory

THE START OF SOMETHING BIG

Charles Dow was born in Sterling, CT, in 1851. Friends and business associates described him as a quiet, subdued, and unpretentious man. In contrast, Edward Jones, four years younger, was a flamboyant man-about-town who enjoyed the Gilded Age social world of New York City. Among his friends were the famous architect Stanford White, members of the prominent and wealthy Astor family, and leading financiers such as James Keene and Phillip Armour.

The tension between the two men, caused by the differences in personal style, was exacerbated when Charles Bergstresser assumed a prominent role in the firm. Bergstresser initially played a subordinate role to Dow and Jones, and was assigned the more tedious chores involved in running the firm, such as arranging delivery of the newsletter by a regiment of local boys. But this changed as Dow and Jones grew apart as Jones became less interested in the day-to-day operations of the firm. At the same time, Dow and Bergstresser grew closer, both personally and professionally. Dow began to rely on Bergstresser to fill the void caused by Jones's lessening interest, a process accelerated by Bergstresser's marriage to a cousin of Dow's wife.

Jones eventually left the partnership in January 1899, in short order becoming a successful stockbroker. He clearly harbored no bitterness about the breakup of his partnership with Charles Dow. When Dow died on December 4, 1902, his old partner wrote the following tribute, published in the newspaper that they cofounded:

May I offer a brief tribute to the memory of your senior partner with whom I worked as an editor 28 years ago in Providence, RI, and whose partner I was in Dow Jones & Company until three years ago. He was always a ceaseless searcher for facts and the best way to tell and distribute them. He was a tower of strength in early struggles to force reluctant railroad managers to furnish reports that tell something to protect the speculating public from swindlers in and out of Wall Street and to praise where praise was due. His honesty was rugged, his industry was prodigious, his integrity unsullied and his home life ideal. Financial journalism loses one of its most honest exponents. His family mourns a devoted, loving son, husband and father, and Wall Street parts with a most conscientious, forceful and able critic. I do not think that his place can be filled.

ENTER BARRON

Financial newspaper publisher Clarence Walker Barron, together with his wealthy wife, Jessie Waldron Barron, purchased Dow Jones & Co. for $130,000 in 1902, shortly before Charles Dow died. Their heirs are major shareholders of Dow Jones & Co. today. After that, the averages that we know today began to evolve.

The averages published in the pages of The Wall Street Journal immediately caught readers' attention; called the Dow Jones averages, they were stock indexes of blue-chip companies, which eventually became accepted measures of the health of the overall market. Although they carried the names of both men, the indexes were solely the creation of Charles Dow.

Dow would also occasionally write editorials about his market philosophy and ideas. These pieces were based on his conviction that "the market is not like a balloon plunging hither and thither in the wind. As a whole, it represents a serious, well-considered effort on the part of far-sighted and well-informed men to adjust prices to such values as exist or which are expected to exist in the not-too-remote future."

PRICE MOVEMENTS

Charles Dow believed that a rational method based on observations of stock performance over the years could be used to accurately determine future stock prices. The key, according to Dow, is to study and understand the patterns, the "movements" of stock prices. He believed that future stock prices could be predicted based upon historical stock performance; that the stock market has, in effect, a collective memory that controls future prices.

It was not until after his death in 1902 that these editorials were published in book form and began to be referred to as Dow theory. Clearly, Dow did not anticipate that his occasional writings would be considered as the basis of a formal broad investment system. Nor did he ever describe his ideas as "Dow theory." Nonetheless, his writings, amplified and elaborated upon by Wall Street commentators after his death, were the basis for the first technical stockpicking system. For this reason, Dow is known as the founder of technical analysis.

Charles Dow concluded that the stock market has three movements that occur simultaneously and interdependently. The first is the movement of share prices from day to day. The second is the "short swing," which was also referred to by Dow as the "medium swing" — the movement of stocks over a period of 10 days to three months. Finally, there is the "main movement," which occurs over at least four years.

Dow asserted that investors should ignore the day-to-day movement of stock prices and concentrate instead on the "short swing." To do so, he said, investors must keep track of the daily price and volume of trading of the stocks they are following and chart this information. An investor's aim, according to Dow, should be to determine what a stock is going to sell for in three months. A stock whose "short swing" is bullish is defined as a company whose share price reaches new highs that exceed prior highs, while a bearish stock is one whose lows exceed previous lows.

Dow saw that many stocks tended to trade within a range of prices. He noticed that when they reached a certain high point, they tended to decline on profit-taking (that is, as some investors translated their paper profits into cash) and then continue to drift down. The top of the range is the resistance level because the stock price appears to resist moving above it, while the bottom of the range is its support. Dow asserted that if a stock broke above its resistance level, it was likely to begin a new bullish phase and form a new resistance level, while if it fell through its support level, it was likely to enter a bearish period.

PRIMARY AND SECONDARY MOVEMENTS

In addition to the daily, short (or medium), and main movements of a stock, Charles Dow said that a stock also had "primary" and "secondary" movements. He believed that the primary movement of a stock represents its long-term potential, but is generally followed by a secondary movement in the opposite direction of between 30% and 40%. According to this principle, if a stock advances in price by $10, it is likely to fall by $3 or $4. In addition, Dow believed that the size of the secondary movement is related to that of the primary movement. Consequently, if a stock price changes dramatically, a significant movement in the opposite direction is likely.

A corollary to this is the observation that a stock price that has crashed is likely to momentarily increase even if the decline is justified. This is referred to as the "dead cat bounce" because of the tendency for even a poor investment to "bounce" if it drops from a significant height. Likewise, if a stock moves sharply higher, pressure will build for the price to drop in the short term as a result of profit-taking.

PRICE PATTERNS

Dow further asserted that stocks trade in patterns that occur over 10-year cycles. This is because, he opined, "the business community has a tendency to go from one extreme to the other." He believed that stocks become overvalued due to overconfidence and then enter a bear market phase, which lasts about five or six years. Then market confidence rises again, but eventually overexpands into unjustified optimism, which causes the cycle to begin again. Early Dow theorists frequently described this pattern as the "panic cycle."

Dow believed that "at the extreme of stock market optimism, you should go short, while at the nadir of pessimism, you should become fully invested in equities." This is an example of classic contrarian investing — buying when most others are selling, and selling when market sentiment says that stocks can only go higher. Dow wrote that "the best profits in the stock market are made by people who get long or short at the extremes and stay for months or years before they take their profit."

Of course, recognizing when a stock has reached its low or high is easier said than done. For this reason, Dow's warning to an investor was to "cut your losses and let your profits run." To do so, he advised that investments should be protected by placing stop-loss orders at a few dollars less than the price paid. This limits losses, he explained, while letting profitable investments "run."

CONCLUSION

Charles Dow's years of experience as a financial journalist were key to his belief that "the surface appearance of the market is apt to be deceptive." However, he was confident an intelligent investor should be able to look beneath the surface in order to make superior profits.

James Maccaro is an attorney and freelance writer. He has written articles for Newsday, Ideas on Liberty, the Massachusetts Law Review, and other magazines. He can be reached at jam@juno.com.

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