According to Charles H. Dow, the primary
trend of the market is the broad, all-engulfing "tide,"
which is interrupted by "waves," or secondary reactions and
rallies. Movements of smaller size are the "ripples" on the
waves. The latter are generally unimportant unless a line (defined as
a sideways structure lasting at least three weeks and contained within
a price range of five percent) is formed. The main tools of the theory
are the Transportation Average (formerly the Rail Average) and the
Industrial Average. The leading exponents of Dow's theory, William
Peter Hamilton, Robert Rhea, Richard Russell and E. George Schaefer,
rounded out Dow's theory but never altered its basic tenets.
As Charles Dow once observed, stakes
can be driven into the sands of the seashore as the waters ebb and
flow to mark the direction of the tide in much the same way as charts
are used to show how prices are moving. Out of experience came the
fundamental Dow Theory tenet that since both averages are part of the
same ocean, the tidal action of one average must move in unison with
the other to be authentic. Thus, a movement to a new extreme in an
established trend by one average alone is a new high or new low which
is said to lack "confirmation" by the other average.
The Elliott Wave Principle has points
in common with Dow Theory. During advancing impulse waves, the market
should be a "healthy" one, with breadth and the other
averages confirming the action. When corrective and ending waves are
in progress, divergences, or non-confirmations, are likely. Dow's
followers also recognized three psychological "phases" of a
market advance. Naturally, since both methods describe reality, the
descriptions of these phases are similar to the personalities of
Elliott's waves 1, 3 and 5 as we outlined them in Lesson 14.