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The Dow Theory is a trading approach formulated by Charles Dow, the founder of The Wall Street Journal and Dow Jones and Company. The works of Charles Dow are considered the foundation of technical analysis in the markets. The Dow Theory attempts to relate fluctuations in the market to previous movements to predict potential future price action reliably.
Dow also believed that the stock market could provide an accurate assessment of the conditions in an economy. He thus created two indices he considered to be an accurate reflection of the broader economy: the Dow Jones Industrial Average Index and the Dow Jones Rail Index (Transportation Index). These indices represented very vital economic sectors at the time.
The Basic Tenets of The Dow Theory
Here are the six basic tenets that underpin the Dow Theory:
The market discounts everything
The Dow Theory follows the philosophy of the efficient market hypothesis. It states that the price of a stock at any given time reflects all available information, known or unknown, by all market participants. The information ranges from specific company news, such as earnings reports and management changes, to macroeconomic factors like monetary policy and the global economy. Furthermore, future events, such as economic news releases, have also been factored into the current price. This is also the philosophy of technical analysis, and it conflicts with the principles of fundamental analysis and behavioural economics.
There are three kinds of market trends
The Dow Theory postulates three kinds of trends based on the duration of time they last. The three types of market trends are: primary, secondary, and minor. Primary trends are major trends that last a year or more. Primary trends can be bullish, bearish, or ranging. Secondary trends are generally pullbacks or countertrends of primary trends; they move in the opposite direction of primary trends. Secondary trends typically last three weeks to three months. Lastly, there are minor trends that last less than three weeks. Minor trends are considered noisy and are generally ignored by long-term investors, although they may offer some great opportunities for aggressive, short-term traders.
Primary trends have three phases
The Dow Theory states that a primary trend will go through three self-repeating phases dictated by the flow on investors’ in the know’ or ‘smart money.’ In a bull market, the phases are the accumulation phase, public participation phase (big move phase), and excess phase. In a bear market, the phases are the distribution phase, public participation phase, and panic phase.
It is always the investors ‘in the know’ who are the market’s protagonists. In a bull market, the savvy investors will be the first to accumulate in anticipation of a significant upward move; and they will be the first to distribute their holdings after the big move in anticipation of a bear market. At both extremes, the ‘sheep’ will buy at the top and panic at the bottom.
Indices must confirm each other
Dow suggested that for a trend to be considered valid, the two indices must confirm each other. It is a clear bull market if both the Dow Jones Average and Transport indices are making higher highs. It is also a clear bear market if both indices make lower lows. There is no clear trend in the market if the indices move in divergent directions. For instance, if the Industrials index is edging higher, but the Transportation index is drifting lower, the bullish breakout in the Industrials is weak or a false signal. Over the years, investors have applied this tenet to other major indices such as the S&P 500 and Nasdaq 100.
Volume must confirm the trend
It is the volume that qualifies trends. Volume should increase in the direction of a trend to provide further confirmation that the prevailing trend is valid. There should be huge concerns if price trends in a particular direction but on low volume. Volume represents the number of transactions taking place or the amount of the transactions. It is smart money that controls vast sums of money, and it is their capital allocation that can sometimes drive trends.
Trends persist until a clear reversal occurs
Dow postulated that trends persist until a clear sign that a reversal has occurred. It is possible to confuse secondary trends with reversals, which is why Dow always advocated for caution when implementing various trend trading strategies. Trends might last longer than you can imagine. This might be the basis of the saying, ‘the trend is your friend until it ends.’
Dow Theory in Technical Analysis
The Dow Theory advocates for a trend-following strategy. Therefore, it is important to identify the best points to enter and ride a new trend and when to exit when a reversal happens.
Here is what constitutes a valid Dow Theory buy signal:
- After the low point of a primary downtrend, a secondary uptrend bounce that exceeds 3% will occur and establish a temporary peak that holds above the previous lows.
- Any subsequent price tumbles will fail to recapture the previous lows.
- A breakout above the temporary peak will trigger a buy signal for the developing bull market.
Here is what constitutes a valid Dow Theory sell signal:
- After the high point of a primary uptrend, a secondary downtrend bounce that exceeds 3% will occur and establish a temporary trough that maintains below the previous highs.
- Any subsequent rallies will fail to recapture the last high point.
- A breakout below the temporary trough will trigger a sell signal for the developing bear market.
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The Dow Theory is the foundation of technical analysis, and its principles are still very valid today. They can be applied in different asset classes and incorporated into different trading strategies.
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- What are the hypotheses of the Dow Theory?
The few hypotheses of the Dow Theory are: The theory is not infallible. The averages discount everything (except acts of God or nature). The market can be manipulated day-to-day, but the primary trend cannot be manipulated.
- Does the Dow Theory really work?
Although it was developed many decades ago, the Dow Theory is still applicable today and it forms the basis of technical analysis as we understand it now.
- Why is the Dow Theory important?
The Dow Theory is critical because it helps traders understand market behaviour better and the relationship between price and volume. It also helps traders to identify trends and exploit the opportunities therein.