Dow Theory suggests the markets are made up of three distinct phases, which are self-repeating. Charles H. Dow wrote below words over 110 years ago on January 31, 1901 these , and they are as relevant for the 21st century as they proved to be for the 20th century.
A person watching the tide coming in and who wishes to know the exact spot which marks the high tide, sets a stick in the sand at the points reached by the incoming waves until the stickCharles H Dow, Wall Street Journal.
reaches a position where the waves do not come up to it, and finally recede enough to show that the tide has turned. This method holds good in watching and determining the flood tide
of the stock market.
Who Developed the Dow Theory?
Charles Henry Dow was born on a farm in Sterling, Connecticut, in November 1851. In 1882, Dow and his friend Jones with Charles Bergstresser , formed Dow Jones &Company and began publishing the handwritten Customer’s Afternoon Letter which later became Wall Street Journal .
A series of articles published in Wall street Journal about stock market behavior by Charles H Dow, later on became the famous Dow theory. The theory has gone through several developments , however the core still remains the same and relevant to the todays stock markets and is the backbone of the modern technical analysis.
What is Dow jones theory?
The Dow theory describes the broad market movement in simple terms. It helps to understand the broad primary , secondary trends and daily fluctuations and other important concepts of bull markets , bear markets , trend lines , reversals etc.
Following are key principles of the Dow theory.
- Three Primary trends in the market
- Phases of the market within primary trends
- Broader market averages must confirm each other
- Relation of volume and price movements
- Definition of a line
- Market discounts everything and no manipulation is possible of primary trend
Lets take a look at these in more details.
Traditional Dow theory
The traditional Dow theory is based on certain hypothesis and theorems which were put out by various followers of the Dow theory such as Robert Rhea , William Peter Hamilton et al.
Traditional Dow theory Hypotheses
- Manipulation : Manipulation is possible in the day – to – day movements of the market averages and of individual stocks. Secondary reactions or secondary trends are less likely to such manipulations but Primary trends can never be manipulated and will always be true in nature.
- Markets/Averages discount everything : The fluctuations of the daily closing prices of the Dow – Jones Rail and Industrial averages is a composite index of all the hopes, disappointments, worries , risks and knowledge of everyone who knows anything of financial matters. For that reason, the effects of coming events (excluding acts of God) are always properly anticipated and factored in their movement.
- The theory is not infallible : The Dow Theory is not an infallible system for beating the markets. Its successful use as an aid in speculation requires serious study, and the summing up of evidence must be impartial.
How the traditional Dow theory works
Lets look at all the key principles of Dow theory and how it all ads up together.
Three Primary trends or movements in the market :
There are three primary trend or movements in the market and all are simultaneously happening at any point of time.
- The primary trend : The primary trend is the broad basic upward or downward movement of the market. This is also known as bull or bear market phases and it may continue for few months or years. It is of utmost importance to predict this trend correctly to invest and be successful in the market. There is no method available to forecast how far in time the trend will last and when the reversal will happen.
- The secondary trend : The secondary trend is the smaller movement within the broad primary trend in opposite direction. A pullback or price correction in a bull market and retracement during bear market are examples of the secondary trends. The secondary trend generally ends to re-establish the broad primary trend. Price correction of 33 to 66 % is often seen in the secondary movement phase. These secondary trends are deceptive in nature and can be easily confused with a reversal of primary trend.
- The Intraday price fluctuations : Stocks move up, down, and sideways every day and for the most part those moves are meaningless. Inferences drawn from one day’s movement of the averages are almost certain to be misleading and are of little value except when “ lines ”are being formed. The day – to – day movement must be recorded and studied, however, only to be used when a series of charted daily movements eventually develops into a pattern that is easily recognized as having a forecasting value.
Phases of the market within the Primary trends
Phases in a primary bear market : A primary bear market is the long downward movement interrupted by important rallies. It generally indicates and overall downtrend in market sentiment and it does not stop unless everything downhill is already factored in the stock prices before they finally start to move up.
There are three phases of the bear market they are called the distribution phase, the public participation phase, and the panic phase. These phases go from complacency, to concern, and finally to capitulation.
Phases in primary Bull market : A primary bull market is a broad upward movement, interrupted by secondary reactions, and lasting for couple of years . During this time, stock prices advance because of a demand created by both investment and speculative buying caused by improving business conditions and increased speculative activity.
There are three phases of bull market accumulation phase, the public participation phase, and the excess phase. These corelate to reviving confidence in the future of the business , buying activity based on company performance and earnings and finally overhype of the prices on hopes and expectations.
Broader market averages must confirm each other
The movements of both the transportation and Industrial stock averages should always be considered together. The movement of one price average must be confirmed by the other average before reliable conclusions can be drawn. Inferences based on the movement of one average, unconfirmed by the other, are almost certain to prove misleading.
Relation of volume and price movements
The volume and price must have good correlation. This means the volumes should increase in the direction of primary trend and must be less or decrease during secondary correction phases.
The volumes should increase during bull run and volume should contract on small declines or corrections. Similar behavior should be seen in case of bear markets.
The other way to look at it is market that is overbought shows declining volume on upward movements and excited volume on declines, this indicates a reversal might be on the card. Similarly in oversold markets declining volume seen during downward movement will indicate reversal.
Definition of Lines
A “ line ”is a price movement extending for few weeks or longer , during which period the price variation of both averages ( Industrial and transportation) move within a range of approximately 5 percent . Such a movement indicates either accumulation or distribution depending upon the primary trend.
Determining the Trend
The trend can be determined by the successive rallies penetrating the previously made highs and declines also ending above pervious declines i.e prices making higher highs and higher lows indicate an primary uptrend. Similarly prices indicating the lower lows and lower highs indicate a primary downtrend.
These peaks and valleys ( troughs) are used to determine the trend. Both the averages should show similar movements to confirm the trend direction and strength.
Double Tops and Double Bottoms.
“ Double tops ”and “ double bottoms ”are of little value in forecasting the price movement and
have proved to be deceptive more often than not.
A reversal in the primary trend is signaled when the market is unable to create another successive higher high and higher low in the direction of the primary trend. For an uptrend, a reversal would be signaled by an inability to reach a new high followed by the inability to reach a higher low. The end of primary trend may or may not immediately result in primary trend in other direction but it eventually will.
The reversal of a downward primary trend occurs when the market no longer falls to make lower lows and lower highs. This happens as the prices falling down make a higher peak than the previous peak and also a higher trough than the previous trough.
Relevance of Traditional Dow theory in 21st century
The principles of Dow theory are as relevant today as they were in last century. These principles still form the backbone of technical analysis and price action trading.
The two averages considered during the original Dow theory can be replaced with more indices or market indicators but the core principles still remain the same as the businesses are interconnected and are affected by overall market sentiment.
The basics of trend analysis , reversal pattern trading and other technical analysis fundamentals provided by the Dow theory are still relevant and applicable today.