5. Dow Theory

Problems with Fundamental Analysis

• When PE and Earnings are neither high nor low, decision making is tough for buy\sell call

• Dow called out requirement of Index, created 1st Index Dow Jones Industrial Average. It is price weighted index, average price of all stock price in Index

• Today, mcap weighted index is used

What Strategy to Apply When

• Life Goals SIP - No check required, continue with SIP

• One time Gift - Check PE and EGR and Buy

  • 100% - If PE and EGR are Low, PE < 20

  • 50% If PE > 20 and PE < 27

  • 0% If PE >27, start SIP of 2 years

• Wealth maximization

  • Check PE

  • Check EGR

  • Apply Dow Theory

Why Dow Theory is required?

• What ToDo if PE\ERG both doesn't come down - How to decide on Buy. Same for Sell.

• Decision Making Simple

• While Fundamental Analysis for PE, ERG is preferred for Investing - Buy\Sell, the in-decisive situation is converted to decisive using the Dow Theory

• Applicable for Wealth Maximization

• Save from Analysis Paralysis

Dow Theory Says

• 3 Trends in Market - Primary, Secondary, Tertiary

• Enter on Primary Trend (Could be 5-6 yrs) - Up or Down Trend

• When market falls - be out throughout the downtrend

Primary Waves

• Higher Tops and Higher Bottom

• Higher Bottom - In Uptrend, Each follow-up bottom is higher than previous bottom

• Lower Tops - In Downtrend, Each follow-up top is lower than previous top

• Primary Up Trend - Defined by Higher Bottom

• Primary Down Trend - Defined by Lower Top

Secondary Waves

• While in Primary Up Trend, T1 => B1 is Secondary Down Trend, Similar T2 => B2

• When the waves go against the Primary Up Trend B2<T2 AND B2>B1, is called Secondary Wave

• If B2 would have gone below B1, i.e. B2 < B1 then T2-B2 would be Primary Down Trend

• While in Primary Down Trend, B1=> T1 is Secondary Down Trend, Similar B2 => T2

• When the waves go against the Primary Down Trend T2 > B2 AND T2<T1, is called Secondary Wave

Example:1 - Primary Down Trend - Buy?

• Market in down-trend at at B4, should it a Buy?

• Check Lower Tops

• Check PE

• Check EGR

• Plan A: If both PE (15) and EGR are Low, Buy

• Plan B: If A is not applicable, Dow Theory will signal Trend reversal and point to Buy

• Say T1 > T2 > T3 and now T3 < T4, This is trend reversal from Down-Trend, and a Dow signal to Buy

• Now at T4: Just Do not Buy, Check for PE and EGR

• Say PE Range is 15 (Low Logically 100/10 Year Gsec Bond) - 30 (Hypothesis of high)

• Low: PE < 20 => 100% of Total Wealth maximization Portfolio

• High: PE > 27 => PE High & EGR High, Don't Buy

• Mid: PE > 20 and PE < 27 => Buy 50% of Total Wealth maximization Portfolio

Example:2 - Primary Up Trend - Buy?

• Market in up-trend at at T4, should it a Buy?

• Check Higher Bottoms

• Check PE

• Check EGR

• Plan A: If both PE and EGR are Low, Buy

• Plan B: If A is not applicable, Dow Theory will signal Trend and point to Buy

• Say T1<T2<T3<T4

• Now price goes above T4, T4 < T5, It is Dow signal to Buy

• Now at T5: Just Do not Buy, Check for PE and EGR

• Say PE Range is 15 (Low Logically 100/10 Year Gsec Bond) - 30 (Hypothesis of high)

• Low: PE < 20 => 100% of Total Wealth maximization Portfolio

• High: PE > 27 => PE High & EGR High, Don't Buy

• Mid: PE > 20 and PE < 27 => Buy 50% of Total Wealth maximization Portfolio

Example: 3 - Primary Up Trend - Sell?

• Market in up-trend at at T4, should it a Sell?

• Check Higher Bottoms

• Check PE

• Check EGR

• Say B1<B2<B3<B4

• Now price goes down B4 > B5, Dow signal to sell

• Low: PE < 20 => Don't Sell

• High: PE > 27 => Sell 100%

• Mid: PE > 20 and PE < 27 => Sell 50%

Example: 4 - False Signal