Stock Market Masters

In Part 3 of this series, we focused on the second tenet of Dow Theory: the market has three trends.  In Part 4 we are going to zero in on the trend a bit more and focus on the third tenet: major trends have 3 phases.

As a quick refresher, the 6 tenets of Dow Theory are:

1. The price discounts everything.
2. The market has 3 trends.
3. Major trends have 3 phases.
4. The averages must confirm each other.
5. Volume must confirm the trend.
6. A trend is assumed to be in effect until it gives definite signals that it has reversed.

Major Trends Have 3 Phases

Way back in the late 1800s when Charles Dow first wrote his observations in the Wall Street Journal very few people had taken the time to actually analyze the moves of a stock, much less the whole market.  The tools of technical analysis were years from being developed, and in many ways people considered the speculation of trading/investing in the stock market nothing short of gambling.  But in his study of market behavior, Charles Dow made some interesting discoveries. One of those discoveries is the order in which people enter the market.  And this order is summed up in the third tenet of Dow Theory: major trends have 3 phases.

1. Accumulation

The first phase of a trend is what Dow termed the Accumulation Phase.  During the accumulation phase Dow theorized that some investors, for whatever reason, were able to foresee the future price of a security and managed to buy at, or near, the low of the stock’s price swing.  Dow said these individuals do not in and of themselves hold enough buying power to move the market, but they begin to buy up stock and “accumulate” their positions in anticipation of the next big move.  As prices stabilize during the accumulation phase, the public begins to trust the market a little more.  Eventually the public begins to put their money into the market, and the accumulation phase completes as we move into the second phase.

2. Public Participation

The Public Participation Phase is where the bulk of the price movement occurs.  During this time the public’s confidence in the stock begins to rise, and more and more people begin to place their money in the trade.  As the buying pressure grows, so does the price of the stock, thus driving the price even higher.  As the price continues to rise, public confidence rises even more, attracting more money and driving the price even higher. Eventually the optimism that drove the stock to its new highs spreads like a virus and most of the available money of the general investor is placed in the trade.  This overexposure leads to a lack of buyers and consequently leads us to the third phase of the trend.

3. Distribution

In the Distribution Phase the very investors who began the move by accumulating their positions are the first to exit the move and “distribute” their positions.  These more insightful investors, who in Dow’s mind somehow foresaw the upcoming move, are also insightful enough to realize the market has moved as far as it will move and the time has come to exit their position.  Dow also points out that while these insightful investors seem to have an inherent understanding of the price move of the stock and close their positions, the public’s optimism is at its highest and begins to attract the latecomers who begin to believe this stock must surely continue higher.  It is during this time that the major news outlets also begin to print the most optimistic news stories, which bolsters the public’s sentiment that things must continue higher. This good press builds the optimism and sets the public at ease.

As the distribution phase gets under way and the original money that started the move in the accumulation phase is removed from the market, the public has fully vested their positions and sits anxiously in anticipation of a continuing higher move.  However, since the availability of fresh funds has dried up and ceased, the continuing rise in price has also ceased.  With the original money now gone from the market, prices begin to fall, and the public-who so eagerly helped to drive the market up in a frenzy with the help of the optimistic news media-now begins to doubt their positions. This doubt leads to an equal and opposite selling frenzy, which drives the market back down-often to the same place it began the move.  Once the stock has been driven back to the lows, the very people who began the accumulation phase and participated in the distribution phase once again enter the market, accumulating new positions in anticipation of the next cycle of rising prices.

For the uneducated investor, this scenario seems like market manipulation.  However, manipulation is not what is occurring-it is insightful market observation.  This tenet is one of Charles Dow’s greatest contributions to the world of market analysis as it gives insight into the cycles of market behavior.  When you understand how market cycles tend to behave, you can learn to enter the markets during the accumulation phase, when most people believe the stock is doomed forever.  And when most consider the stock to be rising to the heavens with no end in sight, you can be insightful enough to know when to close and distribute your positions.  This will make you an exponentially more profitable trader.

It is worth noting that this particular tenet of Dow Theory eventually led to a further study of market behavior, one that focuses entirely on the position of contrary opinion.  Investing as a contrarian can be a very profitable position if and when you understand how to use it.  This subject will be covered in more detail in an upcoming article series.

If you would like to learn how to apply Dow Theory and the theories of contrary opinion to your own trading, please visit our website and sign up for a free class. In our next article, we will look at how the averages work together to forecast the next move and how you can use them to better time your trades and understand the next move of a stock.

Jeremy Whaley is Co-Founder of Trade Smart University where he teaches internet based stock market classes to every day investors. His training and trading style is focused on reading the technicals of the market and allow traders to pull substantial profits no matter which direction the market is moving. If you would like to learn more about how to profit during times of extreme market volatility visit Trade Smart University for your chance to take a free class.

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