Currency Technical Analysis Part 3: Dow Theory – Bull and Bear Markets
In previous articles, we’ve looked at the history of Dow Theory, and why it's the best theory ever, for currency technical analysis. The logic for spotting the big trends follows - and it’s these trends that we want to catch - as they yield the big profits! Hamilton identified three specific phases, in both primary bull markets, and primary bear markets. These stages are a reflection of the psychological state of the market - and their reflection in currency technical analysis. A primary bull market was defined as: a sustained advance, marked by improving fundamentals, and investor confidence - a primary bear market is a mirror image – i.e. the exact opposite of a primary bull market. In both primary bull markets, and primary bear markets, there will always be secondary movements, that run counter to the major trend. While Dow theory was developed for stocks, the format works perfectly, (if not better) in the currency markets. Here we look at a bull market move, as defined by Dow Theory: Primary Bull Market: Stage 1 – Accumulation Hamilton concluded that the initial stages of a bull market were indistinguishable from the last reaction rally, of a bear market. Pessimism, which was excessive at the end of the bear market, still remains at the start of a bull market. It’s at this stage, that professional investors begin to accumulate positions - as the market is cheap, and now offers good value – This is true of any market. In the first stage of a bull market, prices begin to find a bottom, and firm up, as these positions are established. When the market starts to rise, there is skepticism that a bull market is emerging. After the first leg peaks, and starts to head back down - this then confirms the bearish view of the majority. It’s at this stage that careful analysis is needed, with Dow Theory - to determine if the decline is a secondary movement (a correction of the first leg up). If it’s a secondary move, a low forms above the previous low, a period of low volatility will be present as the market firms - and the advance finally starts to get under way. When the previous peak is surpassed, the beginning of the second leg forms - and the move is valid and confirmed. Primary Bull Market: Stage 2 - Big Move The second stage of a primary bull market is normally the longest - and represents an easily identifiable trend – clearly indicated with any form of currency technical analysis. This period sees a sustained advance in prices - it’s a period marked by improving fundamentals, and increased confidence. This is considered the easiest period to make money, as participation is broad and the trend followers are in - and investor confidence is high, with strong buying. Primary Bull Market: Stage 3 – Excess The third stage of a primary bull market is marked by excessive optimism, and excessive speculation. During this third and final stage, the uninformed public are heavily involved. In reaction to this, prices are excessive, as confidence has soared - and greed takes over. Prices are being pushed by investor greed and we all know what happens next! Primary Bear Market: Stage 1 – Distribution Accumulation is the hallmark of the first stage of a primary bull market, and distribution marks the beginning of a bear market - as the "smart money" begins to realize, that prices are too far away from fair value. The public is still full of greed at this stage, and are still heavy buyers – the fundamentals appear to be bullish - but this is how every major bull market ends. Prices start to decline, but most investors remain bullish. After a moderate decline, there is a reaction rally, (secondary move) which retraces a portion of the decline. Hamilton noted that reaction rallies during bear markets were very swift and sharp. This quick recovery movement gives confidence to the bulls - however, the reaction high of the secondary move will form - and will be lower than the previous high. After making a lower high, a break below the previous low, will confirm the bull move is over. The exact opposite happens in a bear market. Dow Theory is the best way to catch a long term a trend, using currency technical analysis - and the logic is easy to understand.
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