Introduction to Dow Theory

Introduction to the Dow Theory Investment Analysis

Charles Dow is termed as the father of technical analysis. Dow Theory is the foundation of all sort of technical analysis what we perform today. Charles Dow and his partner Edward Jones founded Dow Jones and Company in 1882.

Dow never formulated his theory as ‘Dow theory’ rather William Peter Hamilton, Robert Rhea and E. George Schaefer collectively represented his theory naming Dow Theory from series of Wall Street Journal’s where Dow has written his work explaining the concept of the stock market as a measure of health business conditions in an economy.

He said the overall market trend reflect the business condition which if gauged through trends price chart we can find the direction of individual stocks.

Charles Dow was the first one to make effort and express the general trend of the securities market in terms of the average price of a selected few stocks that represented the average price as a whole. Using his theory created, he formulated Dow Jones Industrial Index and the Dow Jones Rail Index.

It was believed that at that period of time Rail and industries were the most dominating corporate enterprises, hence the direction of average price chart formulated by Dow in his indices represented the overall trend of the economy.

The Six Basic Tenets of Dow Theory

Market average discount everything: Market reflects the combined effect of the activities performed by thousands of investors through fluctuations in market price. It is the basket of information that has happened in past, in terms of valuation of securities and indices. The information includes all the events that have happened, day to day fluctuations, emotions of investors and even natural calamities and all other things that affect the supply and demand for corporate securities.

As soon as any new information is available it gets incorporated in stock price. At this point, Dow Theory agrees with one of the premises of Efficient Market Hypothesis (EMH). As Dow Theory is mainly concerned with price only and does not deal with fundamentals, so the idea behind this is that the stock price always incorporates all the happenings among the investors which are reflected by prices and using this present and the future trend can be predicted.

Investors look into the indices pattern formed by the fluctuations of prices of different securities and analyse the trend the market is following and then they decide the time of investment.

The Three Trends of Market

The market has three TRENDS: It has been seen that market always moves in trends, that may be upward trend, that has a pattern of rising peaks, downward trend, that has a pattern of successive lower peaks and a sideway trend, where price fluctuations occur however not in a definite upward or downward direction.

Dow said “Records of trading show that in many cases when a stock reaches the top it will have a moderate decline and then go back again to near the highest figures. If after such a move, the price again recedes, it is liable to decline some distance”.

A trend that follows in the market can be figured into three parts namely Primary, Secondary and Minor which Dow compared with Tide, Wave, and Ripples of the sea.

Dissecting the Trends

The primary trend represents the tide, secondary or intermediate trend represents the wave that makes up the tide and the minor trends behave like ripples on the waves.

The Primary movement of trend usually lasts from less than a year to several years, which can be bullish or bearish depending on the market sentiments of that time duration.

The Secondary or intermediate trend in the market interrupts the progress of price in the primary direction. Normally they last from 3 weeks to several months retracing the primary price change from the previous swing or start of the main movement covering around one-third to two- third of its value (gain or loss).

According to Dow, the Minor trend last from hours to not more than three weeks. This reflects the day to day fluctuations and can be manipulated. The three movements may be simultaneous, for instance, a daily minor movement in a bearish secondary trend in a bullish primary movement.

Phases of Trends

Three phases of Trend: Trend can be framed into three distinct phase namely

An accumulation phase, a public participation phase, and a distribution phase.

Accumulation phase represents the informed buying by most of the smart investors against the general opinion of the market. If the previous trend was down then these smart investors recognize the probability of growth potential of stocks and start accumulation the stocks.

The public participation phase where the trends following investors who follow trend through mathematical tools identify and start participating. This usually occurs when prices have already boosted with the positive business news.

The distribution phase takes place when the bullish nature of market start spreading over media and news channels, economic news becomes better and speculative volume and public participation increases. During this phase, the investors who invested in the first phase start distributing before other start selling their stocks.

Note with the start of accumulation phase, the market tends to start its move towards the bullish side which further converts to a bull market. As the distribution phase starts, the bear market comes into play. Fear and panic start spreading among the investors and the smart investors start distributing booking their profit.

The average must confirm each other: Dow interpreted this by referring to the two indices of railroad and industries that both should show the same direction of the trend as uptrend of one will affect the other in the same sense. As the industry will grow more goods will be produced and there will be need of transportation at large scale hence improving both the business leading to increasing in trend in rail as well as manufacturing industries hence confirming the trend of each other.

The volume must confirm the trend: Dow stated that volume should expand or increase in the direction of a major trend. In an uptrend, volume should increase with an increase in price and lower down with the decrease in stock price. In a downtrend, volume should increase with the price drop and gets lowered as they rally. According to Dow volume was considered as a secondary however important factor in confirming price signals.

The trend remains in effect until it gives definite signals that it has reversed: Dow believed that until a clear signal of reversal is recognised trend will remain same. If there is any change is the price that will be temporary and after some time it will again follow the direction of the trend.
Though the identification of change which is temporary or trend reversal is difficult some technical tools may be used for such prediction.

Bottom Line

Dow theory is among the most widely used techniques to detect the market. Hold a position in the market by getting the concepts of Dow theory to your veins. This difference between an investor and a gambler is that a gambler wildly guesses the market and an Investor predicts the market and concepts like Dow theory are his weapons.