Dow Theory is an early version of technical analysis from observations about how stocks move in trends.
Most of the modern technical analysis tools we use today originate from the Theory that Dow created to help assess the overall business climate rather than a price forecasting methodology.
Table of contents
- The Two Dow Market Averages
- Basic Dow Theory
- Analysing Stocks Using Dow Theory
- Dow Theory FAQ
- Related Information
The Two Dow Market Averages
Dow – a financial journalist in the late 19th century – invented two indices with his partners: the Dow Jones Industrial Average (DJIA) and Dow Jones Transportation Average (DJTA).
The concept is that in a healthy business environment, an increase in the DJIA would result in profits within the railroad sector due to the increased transportation needed to move freight.
Conversely, if DJIA averages were rising but the DJTA was falling, it indicated an unsustainable trend and vice versa.
Initially, there were 12 blue chip stocks in the DJIA and 20 railroad corporations in the DJTA analyses.
Basic Dow Theory
The Dow Theory relies on six assumptions, which dictate how a changing trend is interpreted.
The Market Discounts Everything
Averages used in a Dow Theory analysis are already discounted because the actual market prices of stock already account for the opinions of millions of investors and traders.
The stock price is taken as one inclusive metric, which includes everything that matters, such as environmental, economic or political influences.
Anything that can affect the stock price, such as competitive advantage and future earning potential, is already priced into the stock value, even if the trader does not know the details.
This approach uses an efficient market hypothesis (EMH), which says asset prices incorporate all available information.
Markets follow three trends
At any point, there are three forces at work in the stock market, called:
- Primary or major trends
- Secondary trends
- Minor trends
Primary trends last for at least 12 months but can exist for much longer and result in price movements at 20 per cent or more.
These trends are interrupted by corrections caused by secondary trends.
A secondary trend disturbs the primary trend because it moves in the opposite direction, although it can be challenging to identify a secondary trend while it is still developing.
This corrective trend lasts from three weeks and up to several months and removes at least a third of the price movement but often halts at around a 50 per cent correction.
Minor trends represent day-to-day changes in the average values, lasting less than three weeks and usually a few days. Dow Theory doesn’t place any importance on minor trends.
The three phases of primary trends
A bull market exists when a primary trend pushes increasing price movements. This process includes three phases:
- In the accumulation phase, investors buy up stocks at low prices, often when the economy has not begun to pick up, and stock values are at their lowest.
- This activity results in steady improvements, with activity levels increasing as more investors get on board.
- The stock values see significant advances as more and more retail investors decide to buy in.
There is a different set of three steps in a bear market, which all exist within a declining primary trend:
- Distribution starts when investors that bought early in a bull market begin selling stocks.
- In the panic phase, other buyers recognise the dropping prices, and sales pick up speed until values drop dramatically. Normally, this is followed by a long secondary trend.
- Buyers are discouraged from selling if they held on during the previous panic phase or bought during the recovery stage during the secondary trend.
Regardless of the market movement, a primary trend is always broken into three methodical steps.
Both Dow indices must correlate
The Dow indices, the DJIA and DJTA, must show market averages confirming the other.
Signals from one index must match the next because if the DJIA shows a primary upward trend, but the DJTA is still in a downward trend, traders cannot assume that this represents the start of a new trend.
While there are some scenarios where one index will catch up slower than the other, if they don’t show the same approximate movements, then the trend isn’t considered 100 per cent valid.
Trading volumes confirm a trend
The primary focus of the Dow Theory is price action – not volume. However, the volume should expand in the same direction as the primary trend.
If a primary trend is downwards, the volume should increase, and the opposite if the primary trend is positive.
Low volumes indicate a weaker trend because volumes should rise in a bull market as prices rise and drop during pullbacks in the secondary trend.
Trends remain intact until there is a definitive sign of reversal
Up trends reflect greater highs and more significant lows, and for an uptrend to reverse, the stock prices need at least one peak and one less significant trough.
A reversal isn’t the same as a secondary trend, and it can be tricky to determine whether an upswing is a genuine reversal or a temporary rally that won’t impact the overall direction of the trend.
The Dow Theory recommends a cautionary approach, but the longer a trend has persisted, the less likely it will remain intact.
Analysing Stocks Using Dow Theory
When Charles Dow designed the Dow Theory, he used only closing prices to form his concept and didn’t include any index movements within the trading day.
Closing prices signal a trend rather than any other price fluctuations.
Accurately identifying a trend reversal is one of the complexities of the theory, which primarily relies on a review of stock price peaks and troughs.
The theory assumes that markets will fluctuate rather than flow linearly, but the highs and lows should conform with the general movement.
Increasingly higher peaks and troughs signify uptrends, whereas these become continually lower in a downward trend.
Unless there is a clear indication that a trend has reversed, the consensus is that the trend is continuing.
A market reversal occurs in a market where prices cannot reach another successively higher peak or trough consistent with the primary trend. This metric shows that either an upward or downward trend has begun to reverse.
Dow Theory FAQ
Does the Dow Theory work?
The best way to think of the Dow Theory is as a principle that identifies some of the tenets of stock market performance. It lays down simplified concepts that help to track trends and make independent assumptions about their importance.
Many traders use Dow Theory as a baseline guide but rely on more detailed technical indicators to make active decisions about their position.
The Dow Theory is nonetheless important because it paved the way for technical analysis and is the foundation upon which almost all analytical tools used today are built.
What are the limitations of the Dow Theory?
Dow Theory is widely respected, but a criticism of the DJIA relates to the reliance on price-weighted indices. Each set of company stocks is weighted according to price rather than the size of the market cap.
Trends also occur rapidly and are difficult to identify in advance since the first indicators must already be present for the Dow Theory to recognise the emergence of a new trend.
Indicators can lag behind actual trades, so once a primary trend has been confirmed, an investor could potentially have lost out on the initial momentum or pivotal moments when they could have achieved the greatest profit.
Is Dow Theory relevant in today’s investment market?
Charles Dow believed that the stock market reflects broader economic business conditions and created the Dow Theory to track the climate rather than as a tool to buy and sell stocks.
The idea is that a wider market analysis can accurately gauge market conditions and identify directions of major trends and, therefore, the likely direction of particular stocks.
Even though the Dow Theory is over 100 years old, it remains relevant because the principles still apply and can assist traders in spotting and exploiting market trends.
How do you use the Dow Theory in a practical application?
Dow Theory uses charts like any indicator, often plotting two years of pricing data into a line chart. You can identify the highest and lowest prices, qualify each important marker, and then look for sequences.
Where there are identifiable patterns, the Dow Theory concepts apply to arrive at an anticipated outcome, evidence of a trend, or to qualify a particular phase in the price performance.
Why does the Dow Theory ignore minor trends?
Minor trends are considered speculative movements over the short term, largely irrelevant to longer trends, which can span months or even several years.
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