Dow Theory

The Dow Theory is regarded as one of the earliest forms of technical analysis. It was first introduced by Charles H. Dow, who observed that stock prices tend to move in trends, often in unison, although the degree of movement can differ. In 1897, Dow created two major market averages: the “Industrial Average,” which included 12 blue-chip stocks, and the “Rail Average,” consisting of 20 railroad companies. These averages are now known as the Dow Jones Industrial Average and the Dow Jones Transportation Average. The Dow Theory emerged from a series of articles written by Dow in The Wall Street Journal between 1900 and 1902 and serves as a foundational concept for most modern technical analysis principles. Interestingly, Dow did not use his findings to predict price movements; instead, he viewed them as indicators of the overall business environment. The original intent was not to forecast stock prices, but later interpretations have focused primarily on this aspect. After Dow's passing in 1902, his close friend Samuel A. Nelson sought to clarify Dow's methods in his book, “The ABC of Stock Speculation.” William P. Hamilton, who succeeded Dow as the Editor of The Wall Street Journal, further refined Dow's principles into a cohesive theory, which he detailed in his 1922 book, “The Stock Market Barometer: A Study of Its Forecast Value.” Robert Rhea later analyzed both Dow's and Hamilton's works, refining the Dow Theory into the version we recognize today in his 1932 book, “The Dow Theory.”

Basic Principles of the Dow Theory

The Dow Theory is based on six key assumptions:

1. The Averages Discount Everything
   The averages reflect the collective actions of countless traders, speculators, and investors at any moment. The price of an individual stock incorporates all known information about it. As new information becomes available, market participants quickly adjust prices accordingly. Therefore, every known and anticipated event, as well as any factors affecting supply and demand, is accounted for.
2. The Market Is Comprised of Three Trends
   At any time, the stock market is influenced by three trends: Primary, Secondary, and Minor trends. The Primary Trend, which typically lasts at least a year, can persist for many years and usually results in a price movement of at least 20%. The Secondary Trend acts against the Primary Trend to correct it when it becomes overstretched, lasting at least three weeks but potentially extending for several months. The Minor Trend consists of daily fluctuations, lasting less than six days, and is considered insignificant in Dow Theory.
3. Primary Trends Have Three Phases
   A Bull Market, marked by a rising Primary Trend, generally consists of three phases: The Accumulation Phase, where savvy investors buy stocks at low prices during poor economic conditions; the Advancing Phase, characterized by steady price increases and heightened trading activity; and the Public Participation Phase, where more investors enter the market, leading to significant price gains. Conversely, a Bear Market, defined by a declining Primary Trend, also has three phases: The Distribution Phase, where early investors sell their holdings; the Panic Phase, marked by urgent selling and rapid price drops; and the Final Phase, characterized by less aggressive selling from those who held through the panic.
4. The Averages Must Confirm Each Other
   For a valid trend change to occur, the Industrials and Transports must confirm each other. Both averages need to surpass their previous secondary peaks or troughs to validate a trend change. If they do not align in direction, the trend is not fully reliable.
5. The Volume Confirms the Trend
   While the Dow Theory primarily emphasizes price action, volume serves to confirm uncertain situations. Volume should increase in the direction of the primary trend; it should rise during market declines if the primary trend is down and during market advances if the primary trend is up.
6. A Trend Remains Intact Until It Gives a Definite Reversal Signal
   An uptrend is identified by a series of higher highs and higher lows. For an uptrend to reverse, there must be at least one lower high and one lower low (and vice versa for a downtrend). When both the Industrials and Transports signal a reversal in the primary trend, the likelihood of the new trend continuing is highest. However, as a trend persists, the probability of it remaining intact diminishes.