The Dow Theory is a framework for technical analysis of the market. It comprises several market concepts that attempt to explain how the stock market tends to behave.
The original financial theory posited that if the Dow Jones Industrial Average or the Dow Jones Transportation Average (then known as the Dow Jones Rail Average) advances significantly above a previous important average, the other average will do the same in the near future. Conversely, if one index begins to fall, Dow Theory forecasts that the other will likely follow suit.
Using this theory, investors can form a strategy to buy when the market is low and rising, and sell when it is high and going down.
The History of Dow Theory
Although created more than a century ago, Dow Theory remains popular with traders who commonly use it today. Charles H. Dow, founder of Dow Jones & Company, developed the financial theory in 1896 and created the first stock index, the Dow Jones Industrial Average. Dow, along with Charles Bergstresse and Edward Jones, also co-founded The Wall Street Journal, where Dow published portions of the Dow Theory.
Although Charles Dow died before he could publish the entirety of the ideas that make up the theory, others have published contributions to the theory over the years. Some of these publications include:
• The Stock Market Barometer by William P. Hamilton (1922)
• The Dow Theory by Robert Rhea (1932)
• How I Helped More than 10,000 Investors Profit in Stocks, by E. George Schaefer
• The Dow Theory Today, by Richard Russell (1961)
What Is Dow Theory?
The Dow Theory suggests that traders can use stock market trends to assess the overall economy and the state of various industries and then use it to form an investment strategy. Using the Dow theory, one could understand current market conditions and make predictions about the direction the market would take and, therefore, the direction individual stocks might take.
As the economy has changed over the years, parts of the theory have also shifted. For instance, originally, the theory centered around transportation stocks since the railroad industry was such a significant contributor to the economy at that time. While transportation stocks are still a crucial part of the economy, the Dow theory can apply to all types of industries, including newer ones, and forms the basis of many tools in technical analysis such as the Elliott Wave and accumulation and distribution (A/D).
There are six main principles that make up the Dow Theory. They are:
1. The market discounts everything.
2. There are three kinds of market trends.
3. Primary trends occur in three phases.
4. Indices must confirm each other.
5. Volume should confirm price.
6. Trends persist until there is a clear reversal.
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What Are the Six Tenets of Dow Theory?
Here’s more about each of the six principles and how they apply to both institutional and retail investors.
1. The Market Discounts Everything
Like the efficient markets hypothesis, this theory holds that market prices already reflect all available information, so only future events could affect stock prices. Since stocks are always trading at fair market value and are not under or overvalued, investors should make decisions based on market trends.
For instance, if investors believe a particular company will report positive earnings, the market will already reflect this before the announcement, with demand for shares going up before the release of the report.
Those who rely on technical analysis tend to believe in this theory, but investors who use fundamental analysis don’t agree that market value reflects a stock’s intrinsic value.
Recommended: Intrinsic Value vs Market Value: Key Differences
2. There Are Three Kinds of Market Trends
The second principle of Dow Theory is that there are three kinds of market trends, delineated by their duration.
Primary Trends
These last at least one year and are major market trends including bull trends, bear trends, or sideways trends. They are the most important trends for long term traders to look at, but the secondary and tertiary trends can help identify a specific opportunity such as a reversal in the market.
Secondary trends
These trends only last a few weeks or months. They generally include trends where the price moves in the opposite direction of the primary market trend.
Minor trends or Tertiary trends
Used primarily by day traders, these trends last less than three weeks.
3. Primary Trends are Split into Three Phases
The phases of trends depend on what happened to the price prior to the trend as well as market sentiment. The phase names are ordered differently in a bull and bear market. In a bull market, the phases are: accumulation, public participation, excess and distribution. In a bear market the order reverses.
Accumulation
Assets are low, so smart investors start to buy at this time before the market goes back up.
Public Participation
After the accumulation period and as the market starts to go up, a broader number of investors start to see the trend and begin buying assets, so prices increase significantly and quickly.
Excess and Distribution
In this phase, the general public buys, but informed investors see that the market is at a high and begin selling or shorting the market before it starts to decrease.
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4. Indices Must Confirm Each Other
This principle claims that primary trends observed in one market index need to be the same as trends observed in another market index. Originally, the two important indices were the transportation index and the industrial average, but this has changed with the economy over the years. The same principle now applies to other indices. Although industry and transportation are still linked, today, many goods are digital so there can be an increase in the sale of goods without the same increase in transportation.
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5. Volume Should Confirm the Price
This principle states that a strong market trend should correspond with a high trading volume. If there isn’t a large volume in trading, then a trend is not as strong of an indicator of market direction. A low volume trend may not be an indicator of a larger market move.
6. Trends Persist Until there is a Clear Reversal
Another principle is that a market trend will continue until there is a strong indicator of a reversal. Essentially, the market will continue to rise or fall until a primary trend reversal occurs, so investors should not consider secondary and tertiary trend reversals as larger market trends.
Of course, it can be difficult to spot the difference between a primary and secondary trend, so sometimes a secondary trend may actually show a reversal in the market, and a primary trend may turn out to be a misleading secondary trend.
The Takeaway
The Dow Theory consists of six principles that may be used to help explain how the stock market behaves. Although the Dow Theory is over 100 years old, it is still popular and still widely used today for a reason.
Investors often use the Dow as they’re putting together an investment strategy. The Dow and other trading theories may be helpful as you build an online investment portfolio.
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