Dow theory
The Dow Theory is a foundational concept in technical analysis, originally developed from the writings of Charles H. Dow, who co-founded The Wall Street Journal and created the Dow Jones Industrial Average (DJIA) and Dow Jones Transportation Average (DJTA). The theory was later expanded upon by William P. Hamilton, Robert Rhea, and E. George Schaefer.
✤ Key Points of Dow Theory :
1. The Market Discounts Everything
☛ All current news (earnings, inflation, interest rates, etc.) is already reflected in stock prices
☛ Similar to the Efficient Market Hypothesis.
2. The Market Has Three Trends
Dow identified that market movements can be broken into three types of trends:
a. Primary Trend (Major Trend) – Long-term (months to years)
☛ Bull market: Long-term uptrend
☛ Bear market: Long-term downtrend
b. Secondary Trend – Medium-term (weeks to months)
☛ Corrections within the primary trend
☛ Often retraces 1/3 to 2/3 of the previous movement
c. Minor Trend – Short-term (days to weeks)
☛ Day-to-day fluctuations or noise
☛ Traders usually ignore this in Dow Theory
3. Primary Trends Have Three Phases
Each major trend has 3 distinct phases:
✤ In a Bull Market :
☛ Accumulation Phase – Smart money buys while the general public is pessimistic.
☛ Public Participation Phase – Prices rise, public starts investing, good news spreads.
☛ Excess Phase (Distribution) – Overconfidence leads to overvaluation; smart money starts selling.
✤ In a Bear Market :
☛ Distribution Phase – Smart money sells, prices stagnate or fall.
☛ Public Participation Phase – Panic selling starts, public joins in.
☛ Despair Phase – Market bottoms out, pessimism peaks.
4. The Averages Must Confirm Each Other
☛ Dow Theory uses two indexes: DJIA (Industrials) and DJTA (Transport).
☛ A new high (or low) in one index must be confirmed by the other.
☛ Rationale: Goods are manufactured (industrials) and then shipped (transport) — both must do well for economic strength.
5. Volume Confirms the Trend
☛ Volume should increase in the direction of the trend.
☛ In a bull market, rising prices should be accompanied by high volume.
☛ In a bear market, falling prices should be on high volume.
☛ Low volume during price movements can signal a weak trend.
6. A Trend Remains in Effect Until There’s a Clear Reversal
☛ Trends persist until there is unmistakable evidence that they have reversed.
☛ Reversals are confirmed by patterns (like lower highs/lows or higher lows/highs).
✤ Practical Application of Dow Theory
☛ Identifying the start or end of bull/bear markets
☛ Avoiding trades against the trend
☛ Timing long-term investments
☛ However, it’s not a short-term trading tool and tends to lag, since it waits for confirmation before signaling a change.
✤ Criticisms of Dow Theory
☛ It lags the market (signals come after trends begin)
☛ Focuses only on price and volume, ignoring fundamentals
☛ Based on only two indices (nowadays there are many sectors)
