An Introduction to Dow Theory

Introduction 

 

Charles Dow and Edward Jones were newspaper reporters working in New York who decided to form their own newspaper, and did so in 1882. They formed Dow, Jones and Company with a third silent partner. They specialized in the delivery of accurate financial news. It was a news service and when a story broke, Dow, Jones and Company would write them up and send them out to their customers. 

 

The Wall Street Journal was started in 1899. Dow founded the Dow–Jones Financial News Service and is credited with the invention of stock market averages. Dow Theory is a trading approach developed by Charles Dow who is also known as the father of Technical Analysis.

 

Dow did not think of his theory as a device for forecasting the stock market, or even as a guide for investors, but rather as a barometer of general business trends. He outlined the basic principles of the theory, which was later named after him, in editorials he wrote for the Wall Street Journal.

 

Upon his death in 1902 his successor, as editor of the Journal, William P. Hamilton, took up Dow’s principles and, in the course of 27 years of writing on the stock market, organized them and formulated them into the Dow Theory as we know it today.

 

Long before the time of Dow, the fact was familiar to bankers and businessmen that the securities of most established companies tended to go up or down in price together. Charles Dow is believed to have been the first to make a thorough effort to express the general trend of the securities market in terms of the average price of a selected few representative stocks. 

 

There were two Dow–Jones Averages. One was composed solely of the stocks of 20 railroad companies, for the railroads were the dominant corporate enterprises of his day and the other was called the Industrial Average. 

 

This blog discusses the basic tenets of the Dow Theory in an attempt to understand its implications in the price movements of stocks worldwide.

 

(Must read: Journey of the Dow Jones Industrial Average)

 

 

Basic Tenets of the Dow Theory:

 

1. The averages discount everything:

 

Averages reflect the combined market activities of thousands of investors, including those possessed of the greatest foresight and the best information on trends and events, the Averages in their day-to-day fluctuations discount everything known, everything foreseeable, and every condition that can affect the supply of or the demand for corporate securities. 

 

Even unpredictable natural calamities, when they happen, are quickly appraised and their possible effects discounted.

 

(Also read: Fundamentals of Technical Analysis)

 

2. The markets have three trends:

 

Dow postulated that the market trends can be classified into three trends: primary trend, secondary trend and minor trend.

 

The price of stocks in general, swings in trends, of which the most important are the three trends presented in the Dow Theory. 

 

• Primary Trends: Firstly, major or primary trends are the extensive up or down movements that usually last for a year or more and result in general appreciation or depreciation in value of more than 20%. 

 

• Secondary Trends: Now, movements in the direction of the Primary Trend are interrupted at intervals by secondary swings in the opposite direction—reactions or corrections that occur when the Primary Move has temporarily “gotten ahead of itself.” 

 

• Minor Trends: Finally, the Secondary Trends are composed of Minor Trends or day-to-day fluctuations that are unimportant to Dow Theory.

 

As per the Dow theory, The broad, overall, up and down movements usually (but not invariably) last for more than a year and may run for several years. 

 

So long as each successive rally (price advance) reaches a higher level than the one before it, and each Secondary Reaction stops (i.e., the price trend reverses from down to up) at a higher level than the previous reaction, the Primary Trend is up. (Bull Market) 

 

Conversely, when each Intermediate Decline carries prices to successively lower levels and each intervening rally fails to bring them back up to the top level of the preceding rally, the Primary Trend is down. (Bear Market)

 

It is important to note that no two market cycles are the same. For example, in the Indian context, the bull market of 2003–04 is way different from the bull market of 2013-15 which is completely different from the current bull market. Sometimes the market moves from the accumulation to the distribution phase over a prolonged multi-year period. (The different phases are discussed in greater detail in the next section.)

 

On the other hand, the same move from the accumulation to the distribution can happen over a few months. The market participant needs to tune himself to the idea of evaluating markets in the context of different phases, as this sets a stage for developing a view on the market.

 

(Also read: What is Fundamental Analysis?)

 

3. The market trends have three phases:

 

The Dow Theory suggests the markets are made up of three distinct phases, which are self-repeating. Both primary downtrends (bear markets) and primary uptrends (bull markets) are usually (but again, not invariably) characterized by three phases discussed below. 

 

• Phases of Primary Trend in a BULL MARKET:

 

1. Phase 1: Accumulation: The first is the phase of accumulation during which farsighted investors, sensing that business, although now depressed, is due to turn up, are willing to pick up all the shares offered by discouraged and distressed sellers and to raise their bids gradually as such selling diminishes in volume.

2. Phase 2: Big Move: The second phase is one of fairly steady advance and increasing activity as the improved tone of business and a rising trend in corporate earnings begin to attract attention. 

3. Phase 3: Excess: Finally comes the third phase when the market boils with activity as all the financial news is good, price advances are spectacular and frequently make the front page of the daily papers, and new issues are brought out in increasing numbers.

 

• Phases of Primary Trend in a BEAR MARKET:

 

1. Phase 1: Distribution: The first is the distribution period, farsighted investors sense the fact that business earnings have reached an abnormal height and unload their holdings at an increasing pace. Trading volume is still high, although tending to diminish on rallies.

2. Phase 2: Big Move: The second phase is the panic phase. Buyers begin to thin out and sellers become more urgent; the downward trend of prices suddenly accelerates into an almost vertical drop, whereas volume mounts to climactic proportions.

3. Phase 3: Despair/ Panic: The third phase is characterized by discouraged selling on the part of those investors who held on through the Panic or, perhaps, bought during it because stocks looked cheap in comparison with prices that had ruled a few months earlier. As the third phase proceeds, the downward movement is less rapid, but it is maintained by more and more distress selling from those who have to raise cash for other needs.

 

(Recommended blog: 6 Basic Trading Principles)

 

4. Indices must confirm each other: 

 

In order for a trend to be established, Dow postulated indices or market averages must confirm each other. This means that the signals that occur on one index must match or correspond with the signals on the other.

 

5. Volume must confirm the trend: 

 

In a Bull Market, volume increases when prices rise and dwindles as prices decline; in Bear Markets, turnover increases when prices drop and dry up as they recover.

 

6. A trend is said to be continuous until a reversal is confirmed: 

 

According to this principle, Dow states that a trend is actually one continuous movement and that unless there is some external force acted upon, the trend will not change. If the market is rising, it will more likely continue to rise. If the market is falling, it will more likely continue to fall. If the market is not going anywhere, it will more likely continue to stay within a range.

 

Dow Theory’s Defects

 

• The Dow Theory is too late: 

 

“The Dow Theory is a sure-fire system for depriving the investor of the first third and the last third of every Major Move, and sometimes there isn’t any middle third!”

 

• The Dow Theory is not infallible: 

 

The Dow Theory is not infallible. It depends on interpretation and is subject to all the hazards of human interpretive ability.

 

• The Dow Theory frequently leaves the investor in doubt: 

 

There may be weeks or months (e.g., during the formation of a Line) when the Dow Theory cannot “talk”. There is impatience in the market.

 

• The Dow Theory does not help the Intermediate Trend investor: 

 

It is perfectly true that the Dow Theory does not help the Intermediate Trend investor.

 

(Recommended blog: 7 Commonly-Used Intraday Trading Strategies)

 

 

Final Note

 

This blog discussed the various aspects of the Dow theory, which is one of the most relevant technical analysis theories. Dow theory helps a market participant develop a holistic view of the markets in terms of its trends and phases.

 

(Also Read: 6 Basic Trading Principles)

 

Even though the Dow Theory is hundreds of years old, the implementation of Dow Theory is still as relevant today as ever before.