S.A. Nelson is credited with coining the term "Dow's Theory." In fact, Nelson tried to convince Charles Dow to write a book about his articles in the Wall Street Journal but did not succeed. After failing to get Dow to write a book, Nelson wrote his own based on Dow's writing. The book titled ABC of Stock Speculation neatly lays the groundwork for Dow's Theory to be recognized and interpreted throughout history.
In one excerpt from the book A Treasury of Wall Street Wisdom, Nelson says:
"...stocks have recovered after artificial depression and relapsed after artificial advances to the middle point which represented value as it was understood by those who bought or held as investors."
This means that if an index or stock that has fallen below the halfway point of the previous advance or risen above the halfway point of a previous decline, then the index/stock is either undervalued or overvalued. If the index/stock has fallen close to the prior level of where the advance started and the index/stock is still fundamentally sound then the index/stock could be considered extremely undervalued. Likewise, if the index/stock has risen far above the prior high then it is considered overvalued.
When I start to consider investing in an individual stock, I only want to know if the price of the stock has reached a new 1-year low. From this vantage point, I can determine if the stock is trading at an extreme relative to the halfway point of the previous advance and decline. Again, this approach can only work if the company is generally in fair condition. This means that earnings exist, the dividend payout ratio isn't too high and management has a track record of rewarding the shareholders and etc.
The halfway point of the previous advance or decline is the point at which "long-term" investors would consider the stock or index fairly valued. Traders can take advantage of this fact and use it to their benefit. In the chart below, I show the Dow Jones Industrial Average since 1997.
What is important to notice is that the artificial advance and artificial depression meet at the halfway point of 10,302.31 (dark blue horizontal line.) If drawn backwards to the point when the Dow first went above 10,000, we can see an enormous amount of time spent at or around 10,302.31. This indicates that, for now, "long-term" investors fairly value the market at the 10.3K level.
