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Dow and Hamilton identified three types of price movements for the Dow Jones Industrial and Rail averages: primary movements, secondary movements and daily fluctuations. Primary moves, which can last from a few months to many years, represent the broad underlying trend of the market. Secondary (or reaction) movements, which can last from a few weeks to a few months, move counter to the primary trend. Daily fluctuations can move with or against the primary trend and last from a few hours to a few days, but usually not more than a week.
Primary Movement
Primary movements represent the broad underlying trend of the market and can last from a few months to many years. These movements are typically referred to as bull and bear markets. Once the primary trend has been identified, it will remain in effect until proved otherwise. (We will address the methods for identifying the primary trend later in this article.) Hamilton believed that the length and the duration of the trend were largely indeterminable. Hamilton did study the averages and came up with some general guidelines for length and duration, but warned against attempting to apply these as rules for forecasting.
Many traders and investors get hung up on price and time targets. The reality of the situation is that nobody knows where and when the primary trend will end. The objective of Dow Theory is to utilize what we do know, not to haphazardly guess about what we don't know. Through a set of guidelines, Dow Theory enables investors to identify the primary trend and invest accordingly. Trying to predict the length and the duration of the trend is an exercise in futility. Hamilton and Dow were mainly interested in catching the big moves of the primary trend. Success, according to Hamilton and Dow, is measured by the ability to identify the primary trend and stay with it.
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Secondary Movements
Secondary movements run counter to the primary trend and are reactionary in nature. In a bull market, a secondary move is considered a correction. In a bear market, secondary moves are sometimes called reaction rallies. Earlier in this article, a chart of Coca-Cola was used to illustrate reaction rallies (or secondary movements) within the confines of a primary bear trend. Below is a chart illustrating a correction within the confines of a primary bull trend.
In Sept-96, the DJIA ($INDU) recorded a new high, thereby establishing the primary trend as bullish. From trough to peak, the primary advance rose 1988 points. During the advance from Sept-96 to Mar-97, the DJIA never declined for more than two consecutive weeks. By the end of March, after three consecutive weeks of decline, it became apparent that this move was not in the category of daily fluctuations and could be considered a secondary move. Hamilton noted some characteristics that were common to many secondary moves in both bull and bear markets. These characteristics should not be construed as rules, but rather as loose guidelines to be used in conjunction with other analysis techniques. The first three characteristics have been applied to the example above.
Based on historical observation, Hamilton estimated that secondary movements retrace 1/3 to 2/3 of the primary move, with 50% being the typical amount. In actuality, the secondary move in early 1997 retraced about 42% of the primary move. (7158 – 5170 = 1988; 7158 – 6316 = 842, 842/1988 = 42.35%).
Hamilton also noted that secondary moves tend to be faster and sharper than the preceding primary move. Just with a visual comparison, we can see that the secondary move was sharper than the preceding primary advance. The primary move advanced 38% (1988/5170 = 38%) and lasted from Jul-96 to Mar-97, about 8 months. The secondary move witnessed a correction of 11.7% (842/7158 = 11.7%) and lasted a mere five weeks.
At the end of the secondary move, there is usually a dull period just before the turnaround. This period is usually marked by little price movement, a decline in volume or a combination of the two. Below is a daily chart focusing on the Apr-97 low for the secondary move outlined above.
April 7 through 10 marked the dull point (red line on volume). There was little price movement and volume was the lowest since the decline began. The DJIA ($INDU) then gapped down on an increase in volume. The down gap was followed by a reversal day, after which the DJIA proceeded with an gap up and broke out to a reaction high on increasing volume (green line on volume). The new reaction high, combined with the increase in volume, indicated that the secondary move was over and the primary trend had resumed.
Lows are sometimes accompanied by a high-volume washout day. The September/October lows in 1998 were accompanied by record volume levels.
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