When there is interest rate uncertainty, many of the prominent technicians and historians will hurry forward, offering their expert opinions on the outlook for the U.S. economy. These experts use technical analysis of the various indicators to predict changes in the market cycle. Even if you aren't a well-known analyst, it's important to understand the current trends and make your own decisions about the future direction of the stock market.

While it may be less effective in these days of atmospheric valuations, one of the oldest (and still widely discussed) market indicators is the Dow theory. Before we move further, it must be said that the stock market today is vastly different from that in the early 1900s when Dow formulated his ideas. Today's thirty large companies do not provide a true picture of the broad, technologically oriented 'Corporate America' and the transportation average is far less representative of the economy than it was in the past. To most investors, the value of the Dow theory is that it represents a sound fundamental method that can benefit those who devote time and effort to gaining a basic understanding of the principals involved.

Charles H. Dow was one of the founders of Dow Jones & Company. Dow believed the stock market to be a barometer of business and he was convinced that through the proper analysis, accurate signals could be used identify the beginning and end of bull and bear markets. The purpose of his theory was to predict these turns in the market and to forecast the business cycle or longer movements of depression or prosperity. His idea was based on the belief that stock prices cannot be forecast accurately by fundamental analysis, but that trends, indicated by price movements and volume, can be used successfully to predict future market movements. These trends or cycles can be recorded, tracked, and interpreted because the market itself prolongs movements.

Dow and his disciples saw the stock market as made up of "waves"; the primary wave, which is a bull or bear market cycle of several years' duration, and the secondary (or intermediary) wave, which lasts from a few weeks to a few months. The theory basically states that once a trend of the Dow Jones Industrial Average (DJIA) has been established, it tends to move in that direction until it is canceled by both the Industrial and Transportation Averages. It relies on similar action by these two averages, which may vary in strength but not in direction. As an example; a 'primary bull market' is indicated by a pattern of broad movement, interrupted by secondary reactions averaging at least 24 months, where successive rallies penetrate high points with ensuing declines terminating above preceding low points; and stock prices advance on demand by investors who start buying when business conditions improve; and continue to climb as rampant speculation drives the market higher. The key idea is that a new primary trend is not confirmed until the DJIA and DJTA penetrate their previous positions and the trend remains in progress as long as each new intermediate rise goes higher than the peak of the previous intermediate advance and each new intermediate decline stops above the bottom of the previous one.

Next time you are analyzing charts, take a look at the relationship between these averages and you might find that the ageless theory has some relevance after all...