The Dow Theory

Even now, as I typed in the title to this blog post, I am moaning in pain on the inside. Anyone who has studied Dow Theory in depth knows that the path to comprehensive understanding of Dow Theory is a long and grinding path. And anyone who has ever taken a college Biology course might understand: Dow Theory must be the financial analog to Biology’s “Krebs Cycle/Electron Transport Chain”. But don’t you worry. As Crypto traders, we have some legitimate ignorance on our side, and I won’t be dragging you through the wringer with me yet. See, being a new asset, we do not have a functioning crypto-version of Dow Theory in operation. Not yet anyway. But I’m getting way ahead of myself. For now, just know that someone very smart might one day figure out how to apply this to cryptocurrencies, (If they haven’t already) and when that happens, trading will still, in all likelihood, be going on. Actually, I was pretty certain I had begun to figure it out. But I approached some cryptomarket mathematicians on it, and I was civilly told to go fish. Before I loose all you noobs, let me explain what Dow theory is. I will of course be drawing from my reading of the book “Technical Analysis of Stock Trends”, by Edwards, Magee & Bassetti.

Dow Theory, at it’s core, is a way to tell whether or not a market has changed direction. Whenever someone in authority states that we are definitely in a bull market or definitely in a bear market, it’s certainty is likely due to some Dow Theory analysis. Dow Theory is comprised of 12 very elaborate sets of circumstances, and we will go into some of them but if it’s a simple explanation you’re after take this and close the page: A bear market turns bullish after you get a higher high and a higher low. Conversely, a bull market turns bearish after you get a lower high and a lower low. That’s obvious, so some might insist that to make it Dow Theory, a simple explanation should include the point that, “The averages must confirm”. What the hell does that mean? Well that requires some knowledge of market indices.

The Dow-Jones Industrial Average is a publicly traded stock index. That means that it is a derivative security based on a group of stocks belonging to the most prestigious industrial companies traded. Can we leave DJIA there? I hope so. If you need a breakdown on all of that, Google is your friend. (Otherwise you can leave all this for a minute and go here: https://en.wikipedia.org/wiki/Dow_Jones_Industrial_Average and here: https://www.investopedia.com/terms/d/djia.asp ) Now, remember that I said “Averages”. That’s just one average right. The other average (or index), is the Dow Jones Railroad Average, sometimes called “The Rails”. Well that’s what it was called for years and years. Now we call it the Dow Jones Transportation Average. (https://www.investopedia.com/terms/d/djta.asp & https://en.wikipedia.org/wiki/Dow_Jones_Transportation_Average) These two averages have to confirm with each other for a market reversal! And they have to confirm each other in the manner I just mentioned: higher-highs & higher-lows or lower-highs & lower-lows. That’s it. That’s your simple explanation. I just took two decent paragraphs to simply explain what I told myself was going to be a bare-bones, warp-speed explanation. But Dow Theory is at the heart of technical analysis. Some would say the grandfather of technical analysis, so we all owe it to ourselves to understand it well.

Once I understood all this, I started imagining what a Crypto- Dow Theory would look like. The stock market in the days of Charles Dow was simple. There were industrial stocks, and railroad companies. So it made sense that the two averages should confirm. So what’s our analog in the crypto market? Bitcoin is a store of value first and foremost… I tried to find the 2 overarching types of cryptos and I found 3. Adam Levy over at “The Motley Fool” explains it to us. Bitcoin & Litecoin are “transactional” cryptos, like I said. Ethereum is a “platform” based cryptocurrency, and then there are “applications” built on platforms like ICO’s or “Blockchain Terminal” is my new favorite. So I thought I had it at that point. We could generate some indices based on these categorizations and be on our way to slamming Dow Theory’s face into the proverbial crypto-cake. But I was wrong.

The fatal flaw that I made initially was to imagine the Crypto market as being separate from traditional markets. It’s true that, as it stands now, it is separate in a lot of ways. And to be honest, a lot of people on both sides are happy to keep it that way. The reality is that it’s much more likely that these markets will gradually begin to merge until they are almost indistinguishable from one another. Any cryptotrader not knowing Dow theory will be at a loss, and any traditional trader refusing to engage with crypto will gradually put themselves out to pasture. Centralized or not, stocks, bonds, futures… …all these will likely be put on a blockchain. That will be the beginning. The beginning of the blurring of lines between our respective markets. I came to this realization after exchanging emails with an organization who I thought could accomplish the math.

I found the CCI30 or The Cryptocurrency Index 30 at https://cci30.com/ and I sent them a little email. It read…

“In Dow Theory, Market Technical Analysts and ‘Chartists’, use the correlation/divergence of the Dow Industrial Average and the Dow Transportation Index (Formerly ‘rails’) as an indicator for market reversals and other events. I was wondering if down the line, maybe you guys could gen up 3 separated indices based off of crypto type. i.e., Transactional cryptocurrencies index, to include coins like bitcoin litecoin etc. second; A Platform cryptocurrencies index including coins such as ETH and Tron, and lastly an application/utility cryptocurrency index for ICO’s or coins like ripple. Then crypto market technicians might have a good analog for dow theory operations. thanks for listening.”

to which they responded…

“…the idea is interesting, the only problem is how to categorize the cryptos. For example, are we sure that btc is a transactional one and not just a store of value? ETH is a platform for sure, but as a transactional currency it works better than btc. Some say that XRP should not be considered a crypto at all… So you see we would enter in the field of opinions.
Until the market is more mature, we should stick to the classic definition of currency, which is “medium of exchange and storage of value”. Currently this definition applies to all the cryptos that make part of the index…”

So after reading that you might see how I came to this realization that our markets are destined to merge. Or hey, maybe not. Maybe it all remains fragmented and the only way to get averages will be to start drawing on multiple sources. I guess that’s a possibility too. Blockchain is proving to be disruptive in all sorts of ways, and Charles Dow, even beyond the grave, is not immune. Sorry Charles…

Edwards, R. D., Magee, J. & Bassetti, W. H. C. (2007). Technical Analysis of Stock Trends (9th ed.). Boca Raton, FL: CRC Press & Taylor & Francis Group LLC.

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