Charles Dow Theory
The Dow Theory was established from a series of Wall Street Journal editorials authored by Charles H. Dow from 1900 until the time of his death in 1902. Today even after 110 years they remain the foundation of what we know today as technical analysis. Dow never published his complete theory but several of his followers compiled his works and that has come to be known as "The Dow Theory”.
The Dow Theory has six points:
The stock market discounts all news
The Dow Theory suggests that all information be it of the past, present or future is factored into the prices of stocks and indexes. It includes all micro and macroeconomic factors ranging from inflation to earnings.
It also includes events that are expected to happen and could happen. New information that has not been factored into get factored in as soon as they are available.
A market has three trends
The Dow Theory identifies three trends within the market- major, intermediate and minor. A major trend may last from less than a year to several years. An intermediate trend, which is often a reaction to the primary trend, may last from ten days to three months. A minor trend lasts less than three weeks.
A market has three phrases
Dow Theory suggests that major market trends are composed of three phases: an accumulation phase, a public participation phase, and a distribution phase. In case of a bull market the accumulation phase is the start of an uptrend. It is where the informed investors are actively buying stock against the general opinion of the market. Here a sort of price consolidation takes place after a strong sell off. In the public participation phase the general opinion of the market turns bullish. The business conditions look better. As the good news starts coming in, more and more investors participate. As a result the markets keep moving higher and higher. The final stage is the distribution phase where there is rampant speculation. However sensing that the Bull Run is approaching its end the smart investors who entered in the accumulation phrase start selling off their holdings. Finally the speculation creates a bubble which bursts and leads to the end of the rally.
Market Indexes Must Confirm Each Other
When Dow was considering this point he used two indexes- the Dow Industrial and Rail Averages. Dow stated that to assume that a new trend has begun the two indexes must confirm each other. Through this he meant that the direction of the stock market is a reflection of overall business conditions in the economy. If the two indexes are not moving in the same direction, there is no clear trend in business conditions. As such there the trend in the markets cannot be confirmed. Volume Must Confirm the Trend
This means that the volume should increase when the price moves in the direction of the trend and decrease when the price moves in the opposite direction of the trend to confirm the trend. That is in an uptrend, volume should increase when the price rises and fall when the price falls. When volume increases with the direction of the trend it shows that traders are in the belief that the momentum in the trend will continue. Likewise low volume during the corrective periods of primary the trend shows that most traders are not willing to close their positions because they believe the momentum of the primary trend will continue. If volume runs counter to a trend, it is a sign of weakness in the existing trend signalling that the trend is starting to dissipate as the participants are losing conviction in the trend. Trends exist until definitive signals prove that they have ended
Dow stated that trend should be followed and unless they show definite signs of reversals. There may be temporary corrections to a trend but soon the trend will resume. Traders should look clear signals of trend reversal and not confuse a reversal in primary trend with a secondary trend.
Current Relevance
The Dow Theory had laid down the basic principles of technical analysis. However with the advent of more advanced techniques and tools the Dow Theory needs some expansion. One of the big problems with the theory is that the conservative nature of a trend-reversal signal. A reversal in the bullish and bearish trend is confirmed when there is an end to successive highs and successive lows respectively. However it is difficult to predict the end of trends and by the time it gets confirmed the markets have already move a long way.
However the Dow Theory will always remain important in technical analysis. It was the first step to technical analysis of stocks and even after 110 years its tenants remain very much relevant. One can find Dow Theory playing out in the market moves every now and then. It has been, it is and it will always be the first chapter in technical analysis.
