CHARLES H.

DOW AWARD WINNER • MAY 1994

CHARLES DOW LOOKS AT THE LONG WAVE

Charles D. Kirkpatrick II, CMT
Using the stock market principles outlined by Charles H. Dow, how market price action. Most pure technicians conveniently overlook this
could we look at the long wave in stock prices? because it diverges from a strict price analysis. Unfortunately, investment
Dow published The Wall Street Journal beginning in 1889 and, unfor- analysts have evolved into three camps since Dow – technicians, funda-
tunately, died in 1902. He wrote during a period of generally rising stock mentalists and academics – and as seems to be the way of human nature,
prices from the depression lows in the 1870s to the then all time high in they generally disregard the other’s work to reinforce their own identity.
1901. During that period Dow formulated his theory of the stock market. However, Dow was above all that, (or at least before it), and considered
It consisted of two important components: the cyclical nature of the mar- the economic rationale for a cyclical turn in the stock market just as impor-
kets and in the longer cycle, the “third wave,” the need for confirmation tant as the technical.
between economically different sectors, specifically the industrials and the In the post-1929 era, we now know that the underlying long-term up-
railroads. trend in stock prices can be severely interrupted. From looking at stock
Following an earlier analogy between the stock market and ocean waves prices going back several hundred years we also note that the 1929-1932
during the tidal cycle, Dow hypothesized in his famous Wall Street Journal decline was not an anomaly. It occurs with frightening regularity, roughly
editorial of January 4, 1902: every 40 to 60 years (see Chart B, Dow Jones Industrial, Reconstructed,
“Nothing is more certain than that the market has three well-defined 1700-1940). We call this cycle the “long wave” and ponder on how Dow
movements which fit into each other. The first is the variation due to local would have analyzed it.
causes and the balance of buying and selling at that particular time. The
secondary movement covers a period ranging from 10 days to 60 days, Chart B
averaging probably between 30 and 40 days. The third movement is the Dow Jones Industrial Average
great swing covering from four to six years.” 1700-1940 (Reconstucted)
Some technicians, especially cycle analysts, would quibble with the
simplicity of Dow’s breakdown since there is evidence of other waves with
periodicity between 40 days and four years. However, cycle analysts would
also have to acknowledge that Dow’s breakdown is certainly accurate,
though perhaps not inclusive, and that the periods he mentions are, re-
markably, still the dominant cyclical movements today.
But Dow stopped short at the four- to six-year cycle, essentially the
business cycle. He assumed that stock prices had an underlying uptrend
about which these cycles oscillated. This was consistent with his experi-
ence at the time. Stock prices (see chart A, Dow Jones Industrial, 1885-
1902) had wild gyrations during the late 19th Century, but the underlying
trend was generally upward. He undoubtedly would have added a fourth
wave, or “long wave,” had he lived to see the 1929-32 crash.
As an aside, there are still many analysts, especially academics, who
Chart A believe that the long wave is imaginary. Their thesis is based on the as-
Dow Jones Industrial Average sumption that markets don’t have a “memory.” They argue that today’s
January 1885 - December 1902 (Linear Regression Trend) prices are totally independent of yesterday’s, of last week’s, of last year’s
and certainly of 50 years ago prices. Furthermore, since Fourier trans-
forms and other sophisticated mathematical techniques have been unable
to identify with certainty such cyclicality, it probably doesn’t exist. On the
other hand, new experiments, especially those with non-linear mathemat-
ics, are beginning to knock down the “no memory” thesis. Edgar Peters, in
his book Chaos and Order in the Capital Markets, suggests that the stock
market has at least a four year memory. Professors McKinley and Lo from
Wharton and MIT have demonstrated that stock price action is inconsis-
tent with a “no memory” thesis and are now using non-linear mathematics
to study prices. Professor Zhuanxin Ding from the University of Califor-
nia has shown that stock prices act as if they had long memories. Even
simple moving averages, as studied by two professors at the University of
Wisconsin, Dr. William Brock and Blake LeBaron, can generate profitable
Aside from recognizing that the stock market had a pattern, which is trading signals from prices alone, an inconsistency with the “no memory”
the basis for technical analysis, Dow also recognized, in his theory of con- thesis. The Economist wrote in a special section on the Frontiers of Fi-
firmation between the Industrial Average and the Railroad Average, that nance on October 9, 1993:
there must be an economic rationale for any signals given by the stock

JOURNAL of Technical Analysis • Winter-Spring 2002 6

 “This was a shock for economists. Might chartists, that disreputable band
of mystics, hoodwinking innocent fund managers with their entrail-gazing Chart D
techniques and their obfuscatory waffle about double-tops and channel U.S. Long-Term Interest Rates & Dow Jones Industrial Average
break-outs, be right more often than by chance? How could it be?” 1700-1940 (Reconstucted)

Whether we believe in price memory or not, charts of stock prices since

the South Sea Bubble in 1720 show that there are obviously times when
the stock market experiences enormous, speculative rises and subsequent,
disastrous declines. These major events occur at periods considerably longer
than Dow’s four- to six-year movements. Furthermore, when we look at
other economic data, such as commodity prices, GNP (even U. S. Post
Office revenue), etc., we see the same long-term periodicity.
How would Charles Dow have looked at this long wave price action for
signals? Probably he would have begun by looking only at the highs and
lows of each four- to six-year cycle. Intermediate-term motion would be
largely irrelevant to the long wave. Simplistically, he would likely have
stated that the long wave was up when the tops and bottoms of the four-
year cycles were making new highs, and conversely, when the tops and over the past several hundred years have also had a long wave that has
bottoms were making new lows, the long wave was declining. corresponded in period, if not in turning points, with the stock market (see
In the last 60 years, this approach would have missed the 1929 crash, Chart C, U.S. Long-Term Interest Rates, Reconstructed, 1700-1940). For
but the ultra long-term investor would have sold his stocks in 1930 when this reason, we assume Dow would have looked to the interest rate market
the 1929 low, a four-year cycle low, was broken. It would also have told for confirmation of a trend change in the long-term stock market.
the investor in 1950 that the long wave was turning upward, that it was Looking at interest rate trends, however, is not as simple as looking for
time to invest in the stock market. Unfortunately, there would have been a confirmation in trend between industrials and rails. Long wave interest
several false signals. For example, in the 1970s, two four-year cycle lows rate cycles do not overlap precisely with long wave stock price cycles (see
broke below previous four-year lows, wrongly suggesting that the long Chart D, U.S. Long-Term Interest Rates & Dow Jones Industrial Average,
wave was headed down again. Also, in the 1930s, after the initial bottom Reconstructed, 1700-1940). They will not “confirm” a move to new highs
in 1932, several four-year cycle lows were broken between 1937 and 1949, or lows as the rails will the industrials. It is important that one understand
suggesting that the long-term cycle was turning down again after having more about the history of the long wave direction in interest rates before a
bottomed in 1932. signal can be confirmed for the stock market.
False signals also occurred in Dow’s original work on the four-year The confusing aspect between long wave interest rates and the stock
cycles and are the reason for his turn to confirmation between the Indus- market is that sometimes both can be moving in the same direction and
trial and the Railroad averages. He based his confirming signals on the sometimes each can be moving in opposite directions. This is because
economic assumption that expansion in industrial profits could be a tem- stock prices have a corporate profit or growth component, as well as an
porary anomaly but not if the produced goods were being shipped, by rail- interest rate or alternative investment component. In the former, stock
roads, to customers. A confirmation between the two averages in either prices rise as a result of economic growth, industrial expansion and profit-
direction suggested that the new trend was real. ability along with interest rates; in the latter, stock prices rise as an alterna-
Unfortunately, over the long wave, the theory of industrials versus rail- tive investment to falling yields on fixed income securities. The latter, as
roads breaks down. First, over time, railroads are not always the principal we shall see, is more dangerous.
form of transportation for goods (How do you ship the service industry? When we look at the evidence over the past several hundred years we
and how about canals in the 1830s?), and second, the apparent cause for see alternating periods of rising and falling interest rates. These are called
the long-wave has more to due with capital formation, debt and money “secular” moves and have to do with the expansion and contraction of capital
than with industrial production. and debt.
Money has a price too – the interest rate. Interestingly, interest rates Notice in Chart D that the peak in interest rates always precedes the
long wave peak in stock prices by many years. When interest rates and the
Chart C stock market are both rising together, the industrial growth component is
U.S. Long-Term Interest Rates dominant. The period after interest rates peak is when stock prices rise as
1700-1940 (Reconstucted) an alternative investment. During that period declining interest rates force
yield-conscious investors into alternative investments of lesser quality in
order to maintain yield. Since stocks are the most risky and least quality
investments, they become the final alternative, especially when their price
continues to appreciate as a result of increasing cash flow into the stock
market. The recent conversion of government-guaranteed CD deposits into
stock mutual funds is typical during this period. Unfortunately, it eventu-
ally leads to the declining long wave in stock prices.
Each declining stock market wave has occurred only during a secular
decline in interest rates. Over the past several hundred years, you won’t
see a long wave decline in stock prices while interest rates are rising. De-
clining interest rates at first can cause a financial speculation and an enor-
mous rise as yield is chased through lesser quality, but eventually declin-

JOURNAL of Technical Analysis • Winter-Spring 2002 7

ing interest rates are unhealthy for the long wave in stock prices. With this According to rule #1, the long wave was rising. Interest rates peaked in
in mind, Dow would likely have developed the following confirmation 1920 and declined through 1946. Declining interest rates are a warning to
rules for the long wave in stock prices: be confirmed later by a breakdown in the stock market. Thus, under rule
1. When four-year stock price cycles reach new highs and business-cycle #4, when the stock market broke to new lows in August 1930 (DJIA monthly
interest rates are rising, the long wave is rising. mean = 231), it confirmed the long wave downturn.
2. When four-year stock price cycles break below previous lows and busi- During the 1930s and 1940s, while the initial bottom in 1932 turned
ness-cycle interest rates are rising, the long wave is rising. out to be the actual bottom, the gyrations were large and the stock market
trend generally flat. Interest rates declined until the end of World War II.
3. When four-year stock price cycles break above previous highs and busi-
ness-cycle interest rates are declining, the long wave has been given a Any upward breakout had to be taken skeptically (rule #5).
warning but is still rising. Finally, in March 1950, interest rates broke above their earlier busi-
ness-cycle high (rule #5 and #1). Since rising interest rates are always
4. When four-year stock price cycles break down below previous lows accompanied by a rising stock market long wave, this was the buy signal.
and business-cycle interest rates are declining, the long wave is declin- The DJIA was 249 at the time.
ing. In the 1970s, the stock market broke below its prior four-year cycle
5. After a decline, the long wave will not turn up until business cycle lows in 1970 and in 1974. However, interest rates were still rising and thus
interest rates also turn up. the long wave was still rising (rule #2).
Using this set of rules, let’s walk through the past 75 years using the Interest rates finally peaked in September 1981. This was a warning
accompanying Chart E of long-term U.S. interest rates and the Dow Jones (rule #3), similar to the interest rate peak in 1920, that the long wave was
Industrial Average since 1900. ending. Currently, the stock market has yet to break below a previous
From Dow’s death in 1902 both interest rates and the stock market rose. four-year cycle low and thereby confirm a new decline in the long wave.
The last four-year low was 2340 in the DJIA in 1990*. Should it be broken
Chart E before a higher low is established, we will have confirmation of the down-
U.S. Long-Term Interest Rates & Dow Jones Industrial Average
1900-Present turn in the long wave.
Would Charles Dow have looked at the long wave in this manner? We
don’t know. But his principle of first observing price action simplistically
and then confirming it with other markets, using some economic justifica-
tion, gives us an excellent background for analysis of the long wave and
teaches us to remain broad-minded and rational. His legacy is more than
just a stock market theory. It is a way of thinking that transcends the nar-
row confines and pettiness of much investment analysis.
March 30, 1994

*Note: 8064 in the DJIA in 2001, the NASDAQ has already begun its
long wave decline.
CDK, 2002

JOURNAL of Technical Analysis • Winter-Spring 2002 8