Admittedly, our post on the Dow Theory and exchange traded funds (ETFs) was a bit unclear. A few commenters specifically questioned the "new high" determination.
"New high" in this case does not mean the same thing as "all-time high." It instead is used to determine when the market is on an uptrend and conversely, when it’s on a downtrend.
Backtracking a bit, Dow Theory is based on a few assumptions, outlined in an article from Stock Charts:
- The markets cannot be manipulated. While there are wild days of sharp drops and big highs, everything eventually reverts back to the primary, long-term trend.
- The market reflects all information. Look at the averages. This is why we use the 200-day moving average as an indicator. While there are short-term wild swings in either direction, a long-term average is a much more reliable bellwether for the performance of a stock or ETF.
- It ain’t perfect, but it does provide some guidelines.
The market has three movements:
- Primary, which is the broad, underlying trend
- Secondary, which often go against the primary movement and tend to be reactions
- Daily movements
So, how does one spot those primary trends? One of the people who refined the Dow Theory, William Hamilton, used peak and trough analysis to identify them: an up trend is defined by prices that form a series of rising peaks and rising troughs. In other words, higher highs and higher lows. A downtrend is the reverse of that: lower highs and lower lows.
Knowing the difference between a simple correction and a trend isn’t easy, but Hamilton suggested ignoring moves of less than 3%.
As the Dow begins to turn around and steadily make its climb back to where it was before (and perhaps beyond), investors who want to use the Dow Theory to help them make decisions should therefore look for those "new" highs – not the all-time high (or the all-time low, for that matter).