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Dow Theory

In our previous lesson we learned about Market Structure and trends. In this lesson we'll look at Dow Theory, a theory that is widely considered one of the earliest forms of technical analysis in the western world.

What is Dow Theory?

Dow Theory was originally promulgated by Charles H. Dow who noticed that stocks tended to move up or down in trends, and they tend to move together, although the extent of their movements could vary. He used this knowledge to develop some of the original Dow-Jones Averages that are still in use today. While Charles Dow did not use his observations to forecast potential price movements, he saw it as a barometer of the general business climate. After Dow's death in 1902, his close friend, Samuel A. Nelson attempted to explain Dow's methods in his book, The ABC of Stock Speculation. William P. Hamilton, who succeeded Charles Dow as the Editor of The Wall Street Journal, refined Dow's principles and developed them into a theory, which he explained in his book, The Stock Market Barometer: A Study of Its Forecast Value of 1922. Both Dow's work and Hamilton's work were analyzed and studied by Robert Rhea who refined Dow Theory further into the theory we know today, in his book, The Dow Theory of 1932.

The Tenets of Dow Theory

Dow Theory consists of six tenets that described how the market worked at the turn of the 20th century. In the century that followed, globalization of the economy and the emergence of digitization and automation have altered some of the conditions that led to Dow's observations. However, these tenets still have some relevance. The six tenets are as follows:

The Averages Discount Everything as they reflect the combined activities of millions and millions of traders, speculators, and investors at any one time. Thus, every known and foreseeable event that could affect the averages is already factored into the price, as is everything that could affect the supply and demand of the individual stocks, apart from unforeseeable catastrophes.
The Market has Three Trends:
1. The Primary Trend that is the major trend and usually lasts at least one year but can continue for many years. This trend is usually responsible for a price movement, up or down, of at least 20%. The Primary Trend is interrupted by the Secondary Trend that moves against the Primary Trend to correct it when it becomes over stretched.
2. The Secondary Trend that is an intermediate trend that interrupts the movement of the Primary Trend, moving in the opposite direction at times. However, identifying a Secondary Trend while it is in the process of development is very difficult. The Secondary Trend lasts for at least three weeks but can continue for several months and usually retraces at least ⅓ of the previous price movement. At times the Secondary Trend can fully retrace the preceding movement but it often stops between ½ and ⅔ of the preceding trend.
3. The Minor Trend that is a short-term and interrupts the movement of the Secondary Trend. The Minor Trend is the day-to-day fluctuations of the averages and usually lasts less than three weeks. It is not given much importance in Dow Theory.
The Primary Trends consists of Three Phases though they are ordered differently in bull and bear markets:
- The Bull Market is characterized by an advancing Primary Trend and usually consists of three phases:
  1. The Accumulation Phase occurs when astute investors start buying stocks at low prices from sellers who are under duress as the economic news is still bad and is often at its worst. Trading activity is usually still moderated during this phase but is starting to increase.
  2. The Accumulation Phase is followed by a phase that is characterized by steady advances accompanied by increasing activity as improving corporate begins to draw attention. This is usually the most profitable phase for the technical analyst.
  3. The final phase is characterized by phenomenal advances as more and more of the public are drawn to the market.
- The Bear Market is characterized by a declining Primary Trend and like the Bull Market, it also usually consists of three phases:
  1. The Distribution Phase occurs when the astute investors that bought during the accumulation phase of the previous bull market start to sell their holdings. Trading activity is usually still high during this phase but is starting to decrease.
  2. The Panic Phase follows as buyers thin out and selling becomes more urgent. The downward trend accelerates to a near vertical drop characterized by climatic volumes. This phase is usually followed by a long recovery (Secondary Trend) or sideways movement before the final phase begins.
  3. The final phase is characterized by the discouraged selling of buyers that held through the panic phase or bought during the recovery period. The discouraged selling is not as violent as in the panic phase.
The Averages Must Confirm Each Other. This tenet states that the phases of the two averages must be close. In other words, the two averages must both be moving in the same approximate direction though they need not change direction simultaneously. If the two averages do not conform to the same trend, then the trend is not 100% valid. In his time, the two averages were the Dow Jones Industrial Average and the Dow Jones Transport Averages. In today's market there are additional averages but as the global economy has evolved, the connections between averages or sectors have weakened. This tenet is more applicable to the stock market, commodities, and related markets. It is less applicable to Forex, cryptocurrency, and other markets.
Volume Should Confirm the Trend. Dow recognized the importance of volume confirming price action and stated that the volume should expand in the direction of the Primary Trend. If it did not, then the trend is weak and would not result in a large market move.
Trends Persist Until there is a Clear Reversal. Dow believed that Major Trends continued regardless of market noise until there is a strong indication of a reversal. This means that the market will continue to rise or fall until the Primary Trend reverses direction, regardless of what the secondary and minor trends are doing. Confirmation of a reversal occurs when the Secondary Trend fails to break the high of the Primary Trend in an uptrend, or the low of the Primary Trend in a downtrend; and then breaks the previous low of the Primary Trend in an uptrend or the previous high of a downtrend. In other words, a higher high and higher low is replaced by a lower high and a lower low and vice versa.

Conclusion

We have learned that Dow Theory attempts to identify the primary trend of the market. We have learned that the primary trend consists of three phases: Accumulation, when astute investors start buying stocks at low prices, followed by steady advances that accelerates to phenomenal advances in a Bull Market; and Distribution, when the astute investors start to sell their holdings, followed by panic as buyers thin out and selling becomes more urgent which eventually results in discouraged selling by buyers that held through the panic phase. We have also learned that the trend continues, regardless of market noise, until there is a clear reversal of the trend. These are still important aspects of the market, as is the importance of volume.

These are important concepts for successful trading as it gives us greater insight into what the market is most likely to do in the long term; allowing us to trade in the direction the market is most likely to move. In other words, it allows us to trade in the path of least resistance.

In our next module, we will build upon these ideas as we take a closer look at trends and trendlines. We will learn how to draw trendlines, how and when to adjust trendlines, and how to trade with trendlines.

Previous Lesson

Understanding Market Structure

Next Module

Trendline Patterns