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The Followers Of The Dow

05/07/02 08:12:12 AM PST
by James Maccaro

One theory, many interpretations. Here are four of the earliest interpreters.

Charles Henry Dow cofounded The Wall Street Journal in 1889, created the Dow-Jones Averages shortly thereafter, and wrote groundbreaking editorials for the Journal about his investment ideas. Shortly after Charles Dow's death, Samuel A. Nelson, a financial writer and publisher who was the first to label Dow's ideas as "Dow theory," compiled Dow's writings into a short book called The ABC Of Stock Speculation, published in 1903. In it, Nelson elaborated on Dow's ideas by focusing in particular on the psychology of investing. He felt it was vital for an investor to have confidence in all investment decisions. Otherwise, he reasoned, the investor would buy and sell at the wrong times. By analyzing market psychology, as reflected by stock price movements and the volume of trading, Nelson believed that future prices could be projected.


In his book, Samuel Nelson warned that investors should not overtrade by putting too much money at risk. "Sell down to the sleeping point," he advised — that is, if you are nervous about an investment, reduce the amount of money being risked to a level with which you are comfortable, a level that allows you to sleep soundly at night — even if this means liquidating the entire investment.

One of Nelson's strongest beliefs was that investors should know when to walk away from the stock market. He warned against "doubling up" and trading in the opposite direction when a stock position turns out to be unprofitable; for example, if you sell a stock short (sell borrowed stock in the expectation that the stock's price will decline) that subsequently increases in value, do not go long (buy shares at the higher prevailing price in the hope that it will continue higher). If you lose again after doubling up, the result will be, Nelson warned, "complete demoralization."

An example of such an investor who doubled up to his great detriment was Jesse Livermore, the most famous stock market operator of the 1920s. He thought that the stock market was overvalued in the late 1920s, and so he sat out the great bull market of that period and even lost large sums of money because he went short. By the time of the devastating stock market collapse of October 1929, he had abandoned his short positions and made significant equity investments. Consequently, he not only suffered the frustration of knowing that if he had stuck to his guns he would have made huge profits, but he also had to stomach large losses. He attempted to recoup his money by going long in the early 1930s, only to face financial ruin in the most painful bear market in US history.

Nelson believed in the need to continuously monitor the stock market because of the importance of market timing. "Run quick or not at all," he asserted. By this, he meant that you should only sell a stock at the beginning of its bearish trend or when the stock first begins to falter. If you miss the opportunity, hold on to your investment and ride out the cycle. Nelson came to this conclusion because he thought that it is extremely difficult to know when a stock has hit bottom and a new bullish trend has begun.

Although Samuel Nelson was a pioneer of technical analysis, he also understood the value of fundamental analysis, which calls for the analysis of the operations and prospects of a company before buying the stock. "Value has little to do with temporary fluctuations," he wrote, "but is the determining factor in the long run." Therefore, he concluded, the investor should investigate a business carefully before buying the stock of a company.

Nelson summarized his market philosophy by asking, "What use is it to pile up imposing paper profits if they are all to be swept away when the tidal wave strikes? The only way . . . people can avoid being caught in a panic is by the exercise at all times of great conservatism and considerable skepticism. The successful speculator must be content at times to ignore probably two out of every three apparent opportunities to make money, and must know how to sell and take his profits when the 'bull' chorus is loudest."

Nelson died a few years after Dow's death, and he never reached a large audience. However, he is still a significant figure in the history of stock market analysis because of the role he played in preserving Dow's writings, and in bringing recognition to its broad understanding of the stock market.


The first person to widely publicize Dow theory was William Peter Hamilton, an English reporter who immigrated to the United States in 1899. He immediately went to work for Dow, Jones and Co., and he became editor of The Wall Street Journal in 1907. His 1922 book on Dow theory, The Stock Market Barometer, was a best seller and has gone through many editions.

Unlike Dow, William Hamilton made a conscious attempt to devise a stockpicking system. In articles for The Journal, as well as in his book, Hamilton argued that Dow's ideas served as the basis of a scientific indicator of future market activity.

The most important element of Dow's investment philosophy, according to Hamilton, was his concept of the market being driven by three movements: the movement of daily price changes; the short swing, which reflects short-term trends of from two weeks to a month or more; and the main movement, which occurs over several years. While Dow wrote that the "main movement" generally occurs over at least a four-year period, Hamilton believed that the time frame could be much less.

Hamilton was a proponent of the view that the health of the stock market determined the health of the economy in the near future. He observed on the eve of the great crash of 1929 that "if the stock market was compelled to deflate, as politicians seemed so earnestly to wish, they would shortly after experience a deflation elsewhere which would be much less to their liking."

He correctly predicted the resounding end of the 1920s bull market in an editorial published in The Journal on October 25, 1929, only a few days before the crash. This warning was probably not taken seriously by most readers because Hamilton was infamous for having loudly predicted an imminent bear market in 1926, just prior to the greatest bull market in US history. In this way, Hamilton, who was known as a financial expert during his day, set an example for Federal Reserve chairman Alan Greenspan, who became known for his warnings about "irrational exuberance" in 1996. Both Hamilton and Greenspan were widely derided because both made comments virtually on the eve of a great market upswing, but ended up being vindicated.

Hamilton died in 1929, shortly after he was proved to be correct by the great market crash. However, during his long career, he greatly increased our understanding of how the stock market works. He stated that a bull market always eventually results in the overvaluation of stocks, while in turn stocks become undervalued in bear markets. During a bull market, a temporary downward secondary movement can easily be mistaken for the beginning of a new bearish trend. During a bearish secondary movement, changes in the overall direction of the market take place quickly, whereas the resumption of the major movement is slower.

The stock market represents the sum of all available information about factors that affect business, Hamilton believed. A corollary to this rule is that the stock market "cannot protect itself against what it cannot foresee." Therefore, unforeseen events, such as wars and natural disasters, will cause uncertainty, leading to price declines that will persist as long as the uncertainty is prevalent. Of course, recent events have proven this assertion to be correct.

Hamilton clearly believed that the stock market forecasts the nation's business climate because its value is based on people's assumptions about the foreseeable future. "The big bull market (of the 1920s) was confirmed by six years of prosperity, and if the stock market takes the other direction," he stated, "there will be a contraction in business later."

William Hamilton was a true believer in capitalism when free enterprise was under attack around the world (and even in the United States) by socialists and communists. He made the editorial page of the Wall Street Journal a leading proponent of the free market when many other serious newspapers would not. "We know," he asserted, "now that far from labor creating everything (the preposterous major premise of Karl Marx) labor creates only a fraction of the sum of human wealth compared with the product of brains." He taught that the application of "brains" to the stock market could result in large financial gains.


Another major Dow theory pioneer was Robert Rhea. He differs from his predecessors, including Dow himself, in that he relied on exhaustive statistical information in interpreting Dow theory, which he called "both an art and a science."

Rhea, who was born in 1896, was seriously injured in World War I as a result of service in the US Army Air Corps. To take his mind off his physical problems, Rhea conducted a statistical analysis of the stock market, using Dow theory as his framework. He self-published his findings in 1932. His conclusions were also published in Barron's, which allowed him to reach a wide audience. In 1938, he began issuing Dow Theory Comments, one of the earliest investment newsletters.

He became well known by the late 1930s, but his period of relative fame was brief. He died in 1939 due to a weakening of his lungs by war wounds as well as an earlier bout with tuberculosis.

Although Rhea respected Dow theory, he warned that "the theory is not an infallible system for beating the market." He recognized that there is no sure way to beat the market. "Such a method would, of course, very quickly result in there being no market," he opined. Investors justify their gains because they put their money at risk, and while risk can and should be minimized, it cannot be eliminated. He was a cautious investor and warned that short selling is rarely profitable over a long period of time.

The pivotal act that a successful investor must undertake, according to Rhea, is to determine whether the primary movement of the market is bullish or bearish. He asserted that bull and bear markets last from less than one year to several years. He added that, unfortunately, "there is no known method of forecasting the extent or duration of a primary movement."

A bull or bear market will be interrupted by secondary reactions, he explained. "A secondary reaction is considered to be an important decline in a bull market or advance in a bear market, usually lasting from three weeks to as many months, during which intervals the price movement generally retraces from 33% to 66%" of the primary movement.

Rhea concluded that a bull market goes through three stages: a period of reviving confidence, an advance in stock prices that reflects improving conditions, followed by rampant speculation. "Truly, the termination of bull markets represents a period when nothing can justify the prices at which stocks are changing hands except the hope and expectation of those who are suffering from excessive speculative temperature," he concluded. A bear market, he went on to explain, also goes through three stages: the abandonment of hopes (bearish sentiment), followed by a decline in prices that reflects true business conditions, finally followed by distress selling of securities regardless of value.

Further, Rhea wrote that a primary trend changes from bullish to bearish when stock prices fail to reach new highs and decline below the low reached in the previous secondary reaction. He strongly believed in following the overall trend of particular stocks and of the overall stock market. "Success in both speculation and investment depends upon one's ability to swim with the tide rather than against it," he stated. A stock's performance compared to the overall market is its "relative strength" and is likely to continue. Nonetheless, Rhea added, "there are, of course, some men who buy stocks on a declining market to put away as permanent investments. No criticism is intended of that operation."

Robert Rhea can be considered to have been the first stock chartist because he taught that daily price changes should be charted and studied. Daily fluctuations were meaningless to him unless they formed a "line" or pattern when linked together. He noted that "a series of charted daily movements always eventually develops into a pattern easily recognized as having a forecasting value." He also stated his belief that the volume of trades should be followed because bull markets end during periods of high volume of trading and begin with light volume.

Investors should be mindful not to overestimate their ability to accurately predict the market, Rhea cautioned, adding that "there are many periods when even the most skillful trader is in doubt as to what will happen." Therefore, in his words, "they profit most from Dow's theory who expect least of it."


The fourth and final early developer of Dow theory was Glenn G. Munn, who was a security analyst for Paine Webber in the 1920s and was a leading writer about the stock market. He was the editor of the Encyclopedia Of Banking And Finance and wrote Meeting The Bear Market, an account of the 1929 stock market crash.

He agreed with Charles Dow that price changes fall within three movements, which he characterized as the primary or cyclical movement, the secondary or intermediate swing, and the tertiary movement of daily price changes.

Munn wrote that stock prices will consistently be in motion as investors react to business changes. He believed that primary movements are caused by economic fundamentals, while tertiary movements are almost wholly technical, based on the trading history of the security in question. Secondary movements, he added, are chiefly technical but also respond to economic fundamentals.

To Munn, every price change has significance because it is a forecast of future value. However, "this is not to say that price and volume changes . . . can always be interpreted in a way to permit profitable trades," he explained. Like Rhea, and virtually all successful long-term investors, Munn warned that there are times when it is impossible to determine in which direction the market will go.

The history of the stock market led Munn to conclude that the primary movement usually swings from bullish to bearish, or vice versa, quickly. Stagnant prices indicate that the prevailing trend is likely to continue. For instance, when prices plateau during a bull market, the upswing is likely to subsequently continue. Munn reasoned that if a bear market is to commence, investor confidence must be so weak as to not support prices at a stable level for a prolonged period. Munn applied this rule to the overall market, not to individual stocks.

Munn noted that the beginning of a bear market has almost always been heralded by the collapse of a major corporation. He summed up his stock market credo, and perhaps that of most technical analysts, when he asserted that such investors, whom he called "technicists," are "not disappointed if the market fails to conform to the course predetermined as logical. He takes his signals from the market itself and does not quarrel with it. As a result, he is in step with the market and has no apologies to make if its behavior is counter to preconceptions."

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


Hamilton, William Peter [1922, reprinted 1998]. The Stock Market Barometer, John Wiley & Sons.

Maccaro, James [2001]. "Learning From the Masters," Working Money, Volume 2: June.

Munn, Glenn G. [1930]. Meeting The Bear Market, The Bankers Publishing Co.

Nelson, Charles A. [1903]. The ABC Of Stock Speculation, Wall Street Library: New York.

Rhea, Robert [1962]. The Dow Theory, Rhea, Greiner & Co.

_____ [1934]. The Story Of The Averages, Rhea, Greiner & Co.

Wendt, Lloyd [1982]. The Wall Street Journal: The Story Of Dow Jones & The Nation's Business Newspaper, Rand McNally & Co.

Current and past articles from Working Money, The Investors' Magazine, can be found at

James Maccaro

James Maccaro is an attorney and freelance writer. He has written articles for Newsday, Ideas on Liberty, The Massachusetts Law Review, and other magazines. His law journal articles have been cited in several legal decisions, including by the US Court of Appeals for the DC Circuit and by the US Supreme Court. James A. Maccaro is an attorney and freelance writer. He has written articles for Newsday, Ideas on Liberty, The Massachusetts Law Review, and other magazines. His law journal articles have been cited in several legal decisions, including by the US Court of Appeals for the DC Circuit and by the US Supreme Court. He may be reached at

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