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What Is the Dow Theory?
The Dow Theory, established by Charles H. Dow, posits that the stock market’s direction can be gauged by analyzing the movements of specific market averages. An upward trend is indicated when one of these averages, such as the Dow Jones Industrial Average (DJIA), surpasses a previous high and is supported by a corresponding rise in another average, like the Dow Jones Transportation Average (DJTA). By analyzing these averages, investors can gain insights into the overall business conditions and future market directions.
Key Takeaways
- The Dow Theory suggests that market trends are confirmed when advances in one market average are followed by similar movements in another, such as the DJIA and DJTA.
- According to the Dow Theory, markets experience three types of trends: primary (lasting a year or more), secondary (weeks to months), and minor (days to weeks).
- A primary trend comprises three phases: accumulation, public participation, and excess in bull markets; and distribution, panic, and despair in bear markets.
- For a new market trend to be recognized, both volume and indices must confirm the change, reflecting stronger conviction in the trend’s direction.
- Dow Theory emphasizes the persistence of trends until a clear reversal is identified, using peak-and-trough analysis to track high and low points.
The Origins and Evolution of Dow Theory
The Dow Theory is an approach to trading developed by Charles H. Dow, who, with Edward Jones and Charles Bergstresser, founded Dow Jones & Company, Inc. and developed the Dow Jones Industrial Average in 1896. Dow fleshed out the theory in a series of editorials in the Wall Street Journal, which he co-founded.
Charles Dow died in 1902, and due to his death, never published his complete theory on the markets, but several followers and associates have published works that have expanded on the editorials. Key contributions to Dow Theory include:
- William P. Hamilton’s “The Stock Market Barometer” (1922)
- Robert Rhea’s “The Dow Theory” (1932)
- E. George Schaefer’s “How I Helped More Than 10,000 Investors to Profit in Stocks” (1960)
- Richard Russell’s “The Dow Theory Today” (1961)
Dow believed the overall stock market reflects business conditions in the economy, allowing analysts to assess these conditions and predict market and stock trends.
Aspects of the theory have lost ground—for example, its emphasis on the transportation sector and railroads—but Dow’s approach forms the core of modern technical analysis.
Analyzing the Components of Dow Theory
There are six main components to the Dow Theory.
1. The Market Discounts Everything
The Dow Theory operates on the efficient market hypothesis (EMH), which states that asset prices incorporate all available information.
Earnings potential, competitive advantage, management competence—all these factors and more are priced into the market, even if not everyone knows all or any of these details. In more strict readings of this theory, even future events are discounted in the form of risk.
2. There Are Three Primary Kinds of Market Trends
Markets experience primary trends which can last a year or more, such as a bull or bear market. Within the broader trends, secondary trends make smaller movements, such as a pullback within a bull market or a rally within a bear market; these secondary trends can last a few weeks to a few months. Finally, minor trends can last a few days to a few weeks. These small fluctuations are considered market noise.
3. Primary Trends Have 3 Phases
According to the Dow Theory, the primary bull and bear trends pass through three phases.
A bull market’s phases are the:
- Accumulation phase: Prices rise alongside an increase in volume.
- Public participation (or big move) phase: Retail and average investors begin to notice the upward trend and join in—generally, this is the longest phase.
- Excess phase: The market reaches a point where experienced investors and traders begin exiting their positions while the larger average investing population continues to add to their positions.
A bear market’s phases are the:
- Distribution phase, where news of a decline begins to be distributed throughout the investing community via various channels.
- Public participation phase: Opposes that of a bull market participation phase—average and retail investors are selling stocks and exiting positions to reduce losses. Again, this is generally the longest phase.
- Panic (or despair) phase: Investors have lost all hopes of a correction or full reversal and continue selling at scale.
4. Indices Must Confirm Each Other
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. If one index, such as the Dow Jones Industrial Average, shows a new primary uptrend, but another remains in a primary downward trend, traders should not assume that a new trend has begun.
Dow used the two indices that he and his partners invented, the Dow Jones Industrial Average (DJIA) and the Dow Jones Transportation Average (DJTA), on the assumption that if business conditions were healthy—as a rise in the DJIA might suggest—the railroads would be profiting from moving the freight this business activity required; thus, the DJTA would also be rising.
5. Volume Must Confirm the Trend
Trading volume rises when prices move with the primary trend and falls when they move against it. Low volume signals a weakness in the trend. For example, in a bull market, buying volume should increase as the price rises and falls during secondary pullbacks because traders still believe in the primary bullish trend. If selling volume picks up during a pullback, it could be a sign that more market participants are turning bearish.
6. Trends Persist Until a Clear Reversal Occurs
Reversals in primary trends can be confused with secondary trends. It is difficult to determine whether an upswing in a bear market is a reversal or a short-lived rally followed by still lower lows. The Dow Theory advocates caution, insisting that a possible reversal be confirmed by comparing indexes.
Important Aspects of Dow Theory to Consider
Here are some additional points to consider about the Dow Theory.
The Role of Closing Prices and Line Ranges in Dow Theory
Charles Dow focused on closing prices, disregarding intraday movements of the index.
Line ranges, or trading ranges, are a concept in Dow Theory. These periods of sideways (or horizontal) price movements are seen as a period of consolidation. Therefore, traders should wait for the price movement to break the trend line before coming to a conclusion on which way the market is headed. For example, if the price were to move above the line, it’s likely that the market would trend up.
Identifying Trends and Signals in Dow Theory
One challenging aspect of implementing Dow Theory is accurately identifying trend reversals. Remember, a follower of Dow Theory trades with the overall direction of the market, so it is vital that they recognize the points at which this direction shifts.
One of the main techniques used to identify trend reversals in Dow Theory is peak-and-trough analysis. A peak is defined as the highest price of a market movement in a period, while a trough is seen as the lowest price of a market movement in a period. Note that the Dow Theory assumes the market doesn’t move in a straight line, but rather from highs (peaks) to lows (troughs), with the overall trend of the market trending in a specific direction.
An upward trend in Dow Theory is a series of successively higher peaks and troughs. A downward trend is a series of successively lower peaks and troughs.
The sixth tenet of Dow Theory contends that a trend remains in effect until there is a clear sign that the trend has reversed. Similarly, the market will continue to move in a primary direction until a force, such as a change in business conditions, is strong enough to change the direction of this primary move.
Reversals
A reversal in the primary trend is signaled when the market cannot create successive peaks and troughs in the direction of the primary trend.
During an uptrend, a reversal occurs when the index consecutively fails to reach higher highs and higher lows over a long period. Instead, the index moves in a series of lower highs followed by lower lows.
The reversal of a downward primary trend occurs when the market no longer falls to lower lows and highs. Consecutive higher highs and higher lows in a downward-trending market demonstrate a possible reversal to an upward trend.
Remember that primary trend reversals can take months; a price change over a few months may just be a market correction.
What Are the 3 Trends of the Dow Theory?
The three trends are primary, secondary, and minor. The primary trend is the long-term trend, called a bull or bear. Secondary trends are smaller trends, such as a market correction. Finally, minor trends are day-to-day price fluctuations in the market.
What Is the Goal of Dow Theory?
The overall goal of the Dow Theory is to identify the market’s primary trend through proof and confirmation.
What Factors Affect Dow?
The Dow Jones Industrial Average, known as the Dow, is affected by the prices of the stocks that make up the index. Stock prices are affected by many factors.
The Bottom Line
The Dow Theory attempts to identify the primary trend a market is in. It is comprised of three primary trends, each made up of secondary and minor trends. The theory assumes that the market already has knowledge of every possible factor and that prices reflect current information. This implies that there is no need to investigate further why assets are priced the way they are, but to act on price movements and volume and depend on signals and confirmation for trend reversals.
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