What Is The Dow Theory?

The Dow Theory is a form of technical analysis that uses prices and trading volumes to identify broad movements in the stock market and use the information to trade. It is founded on the principle that the stock market moves in trends that can be analyzed for indication of its future direction.

Charles H. Dow first espoused his theory in a series of 255 editorials in the Wall Street Journal from 1900 to his death in 1902. Dow Theory originally focused on the movements of the Dow Jones Industrial Average and Dow Jones Transportation Average compared to each other.

There are Six Principles that govern Dow Theory analysis:

The Market Discounts Everything

This assumes that the market has perfect knowledge of all material factors that could affect a company’s stock price (the efficient market hypothesis).

There are Three Kinds of Stock Market Trends

According to Dow Theory, there are three types of trends that the stock market goes through:

1. Primary Trend: A primary trend is the overall trend of the market. These trends capture market sentiment and can last for several years. A primary trend has to be confirmed by the DJ Industrial Average and Dow Transporation Average moving in the same direction.
2. Secondary Trend: A secondary trend moves in the opposite direction of the primary trend. A secondary trend can last from several weeks to several months. It not necessarily a market reversal of the primary trend. It could be just a market correction or consolidation.
3. Minor Trend: Minor trends are short-term fluctuations in the market—in other words, “noise” that can be caused by temporary volatility in supply and demand. They move in the same direction as the primary trend and can last from less than a day to two or three weeks.

Primary Trends Have Three Phases

There are three primary trends. Uptrends (bull markets) are characterized by generally posting higher highs and higher lows. Downtrends (bear markets) are characterized by lower highs and lower lows. Sideways trends will have prices moving up and down between solid support and resistance lines but not breaking outside of them in a sustained manner.

Both bullish and bearish primary trends have three phases.

Upward primary trends go through:

1. Accumulation Phase: “Smart money” and astute investors begin buying oversold stocks in anticipation of an uptrend. This can often go unnoticed or written off by the wider public as a temporary correction in the current downtrend or sideways market.
2. Public Participation Phase: This is when the wider investing public realizes that stocks are in a rally and starts to invest, pushing prices higher.
3. Distribution (aka Excess) Phase: This is the point where the early buyers sell into the rally's speculative excess and take profits, “distributing” their holdings to the wider market.

Downward primary trends:

1. Downward primary trends start during the Distribution Phase that ended the bull market. Informed investors are now selling into an overbought market before the average participant realizes that the current downturn is not a temporary correction.
2. Public Participation Phase: This is where the average investor realizes that stocks are in a bear market and begins selling.
3. Panic Phase: This is where negative market sentiment snowballs to a critical level, and large amounts of stock are dumped over a short period. Many of these panic sellers are the same ones that bought at the top of the market and held onto their positions too long on the downward leg, hoping for a rebound to make them whole.

Indices Must Confirm Each Other

Dow Theory states that two major indices must be moving in the same direction to validate a change in the primary market trend. These are usually the Dow Jones Industrial Average and the Dow Jones Transportation Average.

Until these two averages begin moving in the same direction, any changes in the market must be treated as a secondary or minor trend. The two indices can diverge temporarily, but one will eventually move in the same direction as the other.

Volume Must Confirm The Trend

Trading volume is a secondary indicator that can confirm or refute a change in the market’s direction. Rising prices in heavy volume are a bullish sign; falling prices in heavy volume are a bearish sign.

A fall in trading volumes can indicate a weak or weakening trend. On the other hand, falling volumes on a downward market movement accompanied by heavier volumes on higher prices can verify a primary uptrend. The opposite can verify a downtrend.

Trends Persist Until A Clear Reversal Occurs

Primary trend reversals can look like secondary trends before they become established. Dow Theory assumes that a trend remains intact until solid evidence shows that it isn’t. This can be a sustained break above or below established trend lines in heavy trading volume before the indices log a record of a change in direction.

Advantages of The Dow Theory

One advantage of using the Dow Theory is that it encourages investors to think long-term instead of getting caught up in day-to-day price movements. Another advantage is that it is easy to understand. It provides clear principles to identify market trends and track market behavior.

The Dow Theory is constructed to identify and track market trends, giving investors insight into the broad direction of markets.

Disadvantages of The Dow Theory

The Dow Theory is a lagging indicator of the stock market. It is not always accurate in predicting future market direction, and investors who are waiting for verification of a change in trends can miss a large portion of initial price movements.

Another drawback of the Dow Theory is that it only tracks the Dow Jones indices. It does not provide insight into the broader market, including the important tech sector as a whole. It is of limited use in a sideways market, where prices move in a range between major support and resistance levels. Likewise, it is less useful when needing information on price trends for individual stocks.