INVESTING: Dow constructed his averages to do technical analysis

As a technical analyst I am fascinated by history. I was a history major in college, so my interest here predates my addiction to financial markets.

The predictive ability of technical analysis depends on people acting in ways similar to what they did in the past. Which means technicians spend a lot of time studying the past.

Long before fundamental analysis became the standard by which investors attempt to figure out future prices, technical analysis was being used to give traders an edge. There is evidence that charts were used as far back as the 1600s by Japanese rice traders.

This old form evolved into what is today called Japanese candlestick charting. Supposedly there are certain indicators within each candlestick, but I have found that most of them do not have any value.

Next up in the history of technical analysis comes Charles Dow himself. I find it ironic that there are many institutions, corporations and people that use his name but would scoff at the idea that technical analysis works at all. The very foundations of his work and beliefs are centered on technical analysis.

The reason the different Dow Jones averages came into being was so he could measure the markets. Charles Dow believed an event that occurred in the past was likely to occur again in some similar fashion.

Dow constructed the Dow Jones industrial average and the Dow Jones transportation average to study the price behavior of equities. His experiences showed him there was a correlation between the price behavior of industrial and transportation stocks.

For example, if the bulk of the stocks under the industrial basket set a new high that was quickly followed by a new high in the transportation stocks, then the broad market was going to be in a bullish mood for some time. If a new high in one sector was not followed by a new high in the other sector, then the stock market might be experiencing trouble in the near future. This style of analysis is known as Dow Theory.

In the history of academics, the study of business is very young. People have been studying religion and science for thousands of years, but business for less than 200.

A good portion of any business education is spent learning how to value an operation. Models are used for looking at cash flows, debt levels, inventory ratios and tax status. This is called fundamental analysis and it is the type of analysis used by more than 90 percent of participants in the stock market.

Technical analysis disregards all things fundamental and simply looks at the history of prices and volume of whatever tradable instrument is being discussed. Technicians have a strong faith in human nature. We believe people will repeat their past behavior and we use this knowledge to make money in the markets.

Charles Dow laid the foundation for what can still be considered a secret to the markets. Perhaps in the new year you can make it a point to find out a little more about this secret, and maybe it can help you find more financial success. A great resource to get started can be found at www.stockcharts.com.

Hauke is a local money manager. His column appears weekly. Views expressed here are the writer’s. Hauke can be reached at 566-2162 or at keenan@samexcapital.com.