Dow Theory’s Peak-and-Trough Analysis Justified

In the analysis of dynamic financial quantities such as stock prices, equity prices, etc., reasonable results are often obtained if we only consider local maxima (“peaks”) and local minima (“troughs”) and ignore all the other values. The empirical success of this strategy remains a mystery. In this paper, we provide a possible explanation for this success. 1 Formulation of the Problem Peak-and-trough analysis. In the early 20th century, a theory – known as Dow Theory – was developed for forecasting the behavior of different prices, such as stock prices, equity prices, etc. The main idea behind this theory is that: • similarly to calculus, where the important first step in the analysis of a function is finding its local minima and maxima, • the important information about the changes in stock market prices can be obtained if we mark local maxima (“peaks”) and local minima (“troughs”); see, e.g., [4, 6]. This analysis is still in use. The resulting peak-and-trough analysis was widely used in the 1920s and early 1930s, until a paper [3] showed the deficiency of the corresponding forecasting techniques.