Stock Market Masters - 21st Century Use of the Charles Dow Theory, Part 2
In our last article we focused on the history of the man behind Dow Theory.
In this article and each of the subsequent articles I am going to break down the six tenants of Dow Theory and discuss how you can apply this 100-year-old theory to the modern markets of the 21st century.
As a quick refresher, the 6 tenants of Dow Theory are:
This is because most beginning investors/traders have learned at least some basic concepts of investing by following fundamental analysis.
In the world of fundamental analysis an investor studies all the different fundamental factors of a company to determine if it is trading at a fair market value.
These factors include such things as price/earnings ratios, company cash flow, dividend payments, etc.
Most fundamental analysts also look at future projected growth through new product offerings, potential acquisitions, new competition, and other similar factors.
For the fundamental analyst these factors form the basis of their investing decisions.
The goal of the fundamental analyst is to observe all of these various factors and determine what he/she believes the future value of the company will be worth.
If the company's current stock price is substantially below the projected value, then the company is worth investing in.
The strategy of a fundamental investor is to buy a stock when it is trading at a good value and hold it while the stock rises with the company's future performance.
In and of itself there is nothing wrong with the theory of fundamental investing.
But Charles Dow discovered many years ago (over 100!) that it does not take long for the fundamentals of a company to be observed by the majority of the people buying that company's stock.
This observation is the basis for the tenant thatthe price discounts everything.
What Dow meant is simply this: All the fundamental data has already been factored into the purchase of a stock.
Consequently the current price at which a stock is trading is not as much directly related to the fundamental value of the stock as much as it is related to the speculation of the traders as to the future value of the stock.
When I teach this principle to my students, I often say the observation this way: There are only four days a year when the core fundamental data changes for a company (as far as the public is concerned)-the four earnings days.
Earnings are announced once a quarter, and on that day companies come out and make statements concerning overall company health and also give projections for the future earnings.
But the price of a stock changes on a daily basis.
If the fundamental data alone were to determine the price of the stock, then after the initial release of data investors would rush to re-price the stock at a fair market price in line with the company's newly released fundamental data.
Then the price of that stock would stay the same until the next earnings announcement, at which point the investors would again re-price the stock to the current fair market price.
However, this is not what we see.
What we see in the price of a stock is a very quick adjustment in price after earnings are released.
Then every day between this adjustment and the next earnings release the price of the stock moves.
For many stocks that move may be 40-60% or more of the value of the stock! So my question is this: If the core fundamental data only changes four times a year (on earnings day), what causes the price to move the other 361 days a year (holidays and weekends not included)? The answer is investor anticipation, generally through assumed (or speculative) circumstance.
This is exactly what Charles Dow mean when he said the price discounts everything.
The price, as it is reflected today, has already factored in to it the most recent changes in fundamental data.
Thus, all price moves from here forward until the next release of fundamental data is not a reflection of core company value but of the speculation of the traders and investors who are expecting the price to be worth more (or less) in the future.
As an investor this is solid information to know and understand.
What it means to you is it may be useless to spend hours pouring over hard fundamental data.
After all, there are high-paid analysts who do nothing but pour over that very data.
In the words of one of my mentors, "What makes you so special that you are the first to see the opportunity?" (Hint: You're not!) That's why it is beneficial to move beyond fundamental analysis and analyze a stock's price behavior apart from the fundamentals alone.
In this article and each of the subsequent articles I am going to break down the six tenants of Dow Theory and discuss how you can apply this 100-year-old theory to the modern markets of the 21st century.
As a quick refresher, the 6 tenants of Dow Theory are:
- The price discounts everything.
- The market has 3 trends.
- Major trends have 3 phases.
- The averages must confirm each other.
- Volume must confirm the trend.
- A trend is assumed to be in effect until it gives definite signals that it has reversed.
This is because most beginning investors/traders have learned at least some basic concepts of investing by following fundamental analysis.
In the world of fundamental analysis an investor studies all the different fundamental factors of a company to determine if it is trading at a fair market value.
These factors include such things as price/earnings ratios, company cash flow, dividend payments, etc.
Most fundamental analysts also look at future projected growth through new product offerings, potential acquisitions, new competition, and other similar factors.
For the fundamental analyst these factors form the basis of their investing decisions.
The goal of the fundamental analyst is to observe all of these various factors and determine what he/she believes the future value of the company will be worth.
If the company's current stock price is substantially below the projected value, then the company is worth investing in.
The strategy of a fundamental investor is to buy a stock when it is trading at a good value and hold it while the stock rises with the company's future performance.
In and of itself there is nothing wrong with the theory of fundamental investing.
But Charles Dow discovered many years ago (over 100!) that it does not take long for the fundamentals of a company to be observed by the majority of the people buying that company's stock.
This observation is the basis for the tenant thatthe price discounts everything.
What Dow meant is simply this: All the fundamental data has already been factored into the purchase of a stock.
Consequently the current price at which a stock is trading is not as much directly related to the fundamental value of the stock as much as it is related to the speculation of the traders as to the future value of the stock.
When I teach this principle to my students, I often say the observation this way: There are only four days a year when the core fundamental data changes for a company (as far as the public is concerned)-the four earnings days.
Earnings are announced once a quarter, and on that day companies come out and make statements concerning overall company health and also give projections for the future earnings.
But the price of a stock changes on a daily basis.
If the fundamental data alone were to determine the price of the stock, then after the initial release of data investors would rush to re-price the stock at a fair market price in line with the company's newly released fundamental data.
Then the price of that stock would stay the same until the next earnings announcement, at which point the investors would again re-price the stock to the current fair market price.
However, this is not what we see.
What we see in the price of a stock is a very quick adjustment in price after earnings are released.
Then every day between this adjustment and the next earnings release the price of the stock moves.
For many stocks that move may be 40-60% or more of the value of the stock! So my question is this: If the core fundamental data only changes four times a year (on earnings day), what causes the price to move the other 361 days a year (holidays and weekends not included)? The answer is investor anticipation, generally through assumed (or speculative) circumstance.
This is exactly what Charles Dow mean when he said the price discounts everything.
The price, as it is reflected today, has already factored in to it the most recent changes in fundamental data.
Thus, all price moves from here forward until the next release of fundamental data is not a reflection of core company value but of the speculation of the traders and investors who are expecting the price to be worth more (or less) in the future.
As an investor this is solid information to know and understand.
What it means to you is it may be useless to spend hours pouring over hard fundamental data.
After all, there are high-paid analysts who do nothing but pour over that very data.
In the words of one of my mentors, "What makes you so special that you are the first to see the opportunity?" (Hint: You're not!) That's why it is beneficial to move beyond fundamental analysis and analyze a stock's price behavior apart from the fundamentals alone.
Source...