What Is the Dow Theory?
According to the Dow Theory, a financial theory, the market is in an upward trend when one of its averages (transportation or industrials, for example) rises above a significant prior high and is preceded or followed by a rise in another average of a same magnitude. An investor might track the Dow Jones Transportation Average (DJTA) increase to validate an upward trend, for instance, if the Dow Jones Industrial Average (DJIA) rises to an intermediate high.
According to the Dow Theory, a technical framework, if one of the market’s averages rises above a significant prior high and is followed or accompanied by a commensurate rise in another average, the market is likely to be in an upward trend.
In line with the efficient market hypothesis, the theory is based on the idea that the market discounts everything.
According to this paradigm, unless trends change, several market indexes must validate one another’s price action and volume patterns.
Understanding the Dow Theory
Charles H. Dow, who formed Dow Jones & Company, Inc. and created the Dow Jones Industrial Average in 1896 along with Edward Jones and Charles Bergstresser, is credited with developing the Dow Theory, a trading strategy. In a series of editorials published in the Wall Street Journal, which he co-founded, Dow elaborated on the premise.
Charles Dow passed away in1902, and as a result, he was never able to publish his whole theory of the markets. However, a number of his collaborators and followers have since produced writings that go beyond his editorials. The following are some of the most significant additions to Dow Theory:
The Stock Market Barometer, William P. Hamilton (1922)
The Dow Theory by Robert Rhea (1932)
How I Assist More Than 10,000 Investors in Making Stock Profits by E. George Schaefer (1960)
The Dow Theory Today by Richard Russell (1961)
Dow thought that the overall state of the stock market was a good indicator of the general state of business conditions in the economy, and that by examining the market as a whole, one could precisely assess these conditions, as well as determine the direction of major market trends and the probable trajectory of individual stocks.
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How the Dow Theory Works
There are six main components to the Dow Theory.
1. The Market Discounts Everything
The efficient market hypothesis (EMH), which holds that asset prices take into account all available information, is the foundation of the Dow Theory.
Competitive advantage, managerial skill, earnings potential—all of these and more are elements that are priced into the market, even if not everyone is aware of all of them. Stricter interpretations of this theory discount risk, including future events.
2. Three Primary Kinds of Market Trends
There Are Three Primary Kinds of Market TrendsPrimary trends in markets, such a bull or bear market, can persist for a year or longer. Secondary trends, which can span a few weeks to several months, are tiny moves within the larger trends, such as a retreat within a bull market or a rebound within a bear market. Lastly, little trends may persist for a few days or a few weeks. These tiny variations are seen as noise in the market.
3. Primary Trends Have 3 Phases
According to the Dow Theory, the primary bull and bear trends pass through three phases.
A bull market’s phases are the:
Phase of accumulation: As volume increases, prices also rise.
Period of public participation (or major move): Typically the longest period, this is when average and retail investors start to notice the upward trend and join in.
Phase of excess: When the market reaches a certain level, traders and experienced investors start to reduce their holdings while the majority of average investors keep adding to them.
A bear market’s phases are the:
Phase of distribution: information about a downturn is started to spread among investors through a variety of media.
Phase of public participation: Differs from a bull market phase in that average and retail investors are selling stocks and liquidating positions in order to minimize losses. Once more, this is usually the longest stage.
Phase of panic (or despair): Investors continue to sell in large quantities having given up on any chance of a correction or complete turnaround.
4. Indices Must Confirm Each Other
Market averages or Dow postulated indexes have to support one another in order for a trend to be declared. This implies that signals appearing on one index and signals appearing on the other must coincide or match. Traders shouldn’t assume that a new trend has started if one index, like the Dow Jones Industrial Average, displays a new primary uptrend while another continues in its primary declining trend.
5. Volume Must Confirm the Trend
In general, trading volume goes up when the price follows the main trend and down when it goes against it. Low volume indicates that the trend is weakening. For instance, because traders continue to believe in the primary positive trend, purchasing volume should rise in a bull market as prices rise and decrease during secondary pullbacks. During a decline, an increase in selling volume may indicate that more market players are becoming negative.
6. Trends Persist Until a Clear Reversal Occurs
Primary trend reversals can be mistaken for secondary trend reversals. It is challenging to distinguish between an upswing in a bear market that is a reversal and a brief recovery that is followed by even lower lows. The Dow Theory advises caution and demands that index comparisons be used to verify any potential reversal.
What Are the 3 Trends of the Dow Theory?
The main, secondary, and minor trends are the three. The long-term trend, also referred to as a bull or bear, is the main trend. Smaller trends, like a correction in the market, are called secondary trends. Lastly, daily changes in market prices are considered minor trends.
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What Is the Goal of Dow Theory?
The overall goal of the Dow Theory is to identify the market’s primary trend through proof and confirmation.
What Factors Affect Dow?
The values of the stocks that comprise the index have an impact on the Dow Jones Industrial Average, or simply the Dow. Numerous factors influence the price of stocks.
The Bottom Line
The Dow Theory looks for the main trend that a market is following. It consists of three main trends, each of which has smaller, ancillary trends. According to the notion, prices represent the most recent information available and the market is already aware of every potential factor. This suggests that instead of looking into why assets are priced the way they are, one should respond to changes in price and volume and rely on signals and confirmation when a trend is about to change.