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Dow Theory

 

The term Dow Theory refers to a body of knowledge which
underpins key aspects of contemporary technical analysis.
There are six key tenets of Dow Theory.

Understanding the basics of Dow Theory will help with
understanding the underlying mood and sentiment of the market participants.
And the broad subject of technical analysis becomes a lot clearer.
Introductory information is included below....

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Related linksTrends and Trend-spotting; Stop Loss; Support and resistanceWeinstein's 30-week MA

Introduction

The term Dow Theory refers to a body of knowledge (a collection of ideas) that was first observed by Charles Dow, and then expanded in numerous writings by others including: William P. Hamilton, Robert Rhea and E. George Schaefer.

Dow Theory is very relevant today as a lot of what we refer to as Technical Analysis is based on the principles of Dow Theory. It is very important for technical analysts to have some knowledge of Dow Theory as the basic principles are very sound, and of great value when they are clearly understood. This cannot be over-stated.

The information here is only an introduction to the topic, and readers should refer to the eBook (PDF) Article mentioned at right, and additional resources.

Who was Charles Dow?

Charles H. Dow (1851–1902) was the founder and first editor of the Wall Street Journal, and co-founder of Dow Jones and Company. He was the person who devised the stock market index which is known today as the Dow Jones Industrial Average (DJIA). Charles Dow did not actually write down what we now refer to as Dow Theory; but he talked about the subject extensively and in his editorial writings in the newspaper. Compiling, interpreting and extending the Dow Theory body of knowledge was done later by his associates. 

Dow talks about the “averages”

Throughout Dow's writings, and the subsequent materials on this topic, there is constant reference to the “averages”. This is a reference to the stock market indexes — the Dow Jones Industrial Average DJIA (an index of the industrial or manufacturing companies), and the Transport Average (an index of rail companies, formerly known as the Dow Jones Rail Index, as rail was the major method of shipping goods around the country). This is a reference to key indexes on the US market, but the principle also applies in other markets in other countries.

Basic principles of Dow Theory

The six basic principles of Dow Theory can be summarised as follows, with more detail below.
  • The averages (ie. the market indexes) discount everything.
  • The market has three main movements (market trends).
  • Primary movements (or market trends) have three phases.
  • Determining the trend (see information about trend-spotting).
  • Both averages must confirm (see comments above).
  • Volume provides additional evidence.

1. The averages (ie. the market indexes) discount everything

The first basic premise of Dow Theory is that all information is already factored into the markets. This refers to all information — whatever is already known — related to companies, the economy, weather, climate, and even emotions. This idea can easily be extended to refer not just to the averages (the major indexes) but the whole of the market, including sub-indexes, sectors and even individual companies.

2. The market has three main movements

The stock market has three main movements, or major trends:
  • The main (primary) movement (or trend) can last from less than a year, but up to several years. It can be bullish or bearish.
  • The medium movement of the market (also referred to as a secondary reaction) can last from about 10 days up to several months. It is a retracement of the major trend (ie. a decline in a bull market). Often, the secondary reactions (retracement) will retrace between one third and two thirds of the last primary move.
  • The shorter movement can be only hours, or maybe days in duration. Sometimes simply referred to as daily fluctuations.

3. Primary movements (or market trends) have three phases

Dow Theory asserts that the market often (but not always) exhibits three major phases in the primary movement (in either a bull or bear market).

In a bull market, the primary trend is characterised by the following three phases:
  • Accumulation Phase — Informed market participants start to quietly buy up stock from distressed investors often at bargain basement prices. 
  • Public Participation Phase — This phase gets under way when the general public realise that the informed buyers have been busy accumulating stock. So they decide to get on board as well.
  • Excess Phase — This is characterised by irrational exuberance and rampant speculation. This phase is where some people realise they have been missing out, so they decide to get into the market. 
In a bear market, the primary trend is often characterised by the following three phases:
  • Distribution Phase — Informed market participants are selling their positions to unsuspecting people at the top of the market, and the market starts to lose momentum and fall away as the pool of willing buyers dries up.
  • Public Participation Phase — This phase gets under way when the general market participants realise that the market has peaked, and that it is time to get out. So there is an abundance of sellers, and prices fall faster and faster.
  • Panic Phase — This phase is where people have had a gut-full of falling prices and can't take any more, so they dump their stock out of fear of losing everything. It generally concludes with what we call capitulation, and blood on the streets.

4. Determining the trend — A trend remains in effect until clear reversal

A basic principle in Technical Analysis is the idea of investing in the direction of the trend. Hence it is very important to be able to identify and confirm a trend. Continuing this line of thinking, it is important to be able to recognise when a trend has finished. A conclusion from this is the Dow Theory tenet that a trend is in place until it is confirmed to have ended. Or in other words: a trend is a trend until it is not a trend. Also see more details about trends and trend-spotting.

5. Both averages (ie. market indexes) must confirm each other

According to Dow Theory, for a major reversal to be confirmed, it must be apparent in “both indexes”. That is in both the DJIA and the Transport Average. This is because a bull market (in the whole of the stock market) cannot be under way if one of the major indexes is not yet demonstrating a bull market. A falling US Transport Average suggests that the transport companies are not shipping goods around the country, which means if factories are producing, then the goods are stock-piling.

Now you might wonder if this reference to the US market averages is as valid today as it was a hundred years ago. The US economy is still the world's largest economy, and this comparison of the two averages is still reasonably valid.

In the Australian market, we can look at the individual sector indexes for clues as to the existence of a bull or bear market. But with several rather specific sector indexes, the situation is rather cloudy when looking for confirmation from all of the sector indexes.

Also see comments above regarding the averages.

6. Volume provides additional evidence

Dow Theory suggests that the volume of stock sold can be used as an additional indicator to help confirm what the price movements are suggesting. When prices increase, an increase in volume indicates buying pressure and support for higher prices. That is, people are prepared to keep paying higher prices. During an uptrend, the short term pull backs or retracements generally experience lower volume, because people are not willing to sell their stock at these prices as they believe that higher prices can be achieved.

Conversely, if we see lower volumes while the prices are rising, this suggests less support for the higher prices and that some form of correction could be due. The correction might simply be a minor pull back, or it could develop into a change in trend.

The bottom line here is that volume is important. It pays to study volume as well as price action.

More information?

The revered bible on this subject is:"Technical Analysis of Stocks and Trends", Edwards and Magee.
For more details see the More Information links at the top of the column at right.
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More Information

eBook (PDF) Articles - Share Market Toolbox Members can see more details in eBook Articles and web pages:
(Toolbox non-Members can see the "Page 1" of eBook Articles from the Master List page.)

Also see: Wikipedia.

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