The Dow Theory is a financial theory promulgated by Charles H. Dow and published in The Wall Street Journal between 1900 to 1902.
Charles H. Dow was an American journalist who co-founded Dow Jones & Company, Inc. with Edward Jones and Charles Bergstresser. Dow also co-founded The Wall Street Journal and developed the two broad market averages – The ‘Dow Jones Industrial Average’ and the ‘Rail Average’.
The Dow Jones Industrial Average included 12 blue-chip stocks and the Rail Average was comprised of 20 railroad enterprises.
Charles Dow died in 1902 and never got to publish his complete theory. However, close friends and followers followed up on his work and published the following over the years:
- The ABC of Stock Speculation (1903) by Samuel A. Nelson
- The Stock Market Barometer (1922) by William P. Hamilton
- The Dow Theory (1932) by Robert Rhea
- How I Helped More Than 10,000 Investors to Profit in Stocks (1960) by E. George Schaefer
- The Dow Theory Today (1961) by Richard Russell 1
Even though some parts of the Dow Theory are no longer as relevant, it is still considered by many to be the foundation for modern technical analysis.
Principles of the Dow Theory
The Dow Theory comprises six principles:
1. The market discounts everything.
The Dow Theory is based on the efficient-market hypothesis (EMH), which states that asset prices reflect all available information.
Everything is priced into the market, even if not everyone knows all or any of these details. This includes everything directly or indirectly related to an asset or its operation – earning reports, company news, management changes, global economic situation, etc. Furthermore, all foreseeable events are also priced into the market.
However, black swan events occasionally occur which are extremely unexpected events that have the potential to severely affect the market.
2. There are three kinds of market trends.
- Primary/major trend.
This trend usually lasts at least one year and can continue for many years. This trend is usually responsible for a price movement, up or down, of at least 20%. 2 - Secondary trend.
This trend will usually at least three weeks and can continue for several months. The secondary trend interrupts and moves opposite the primary trend. It usually retraces at least 1/3 of the primary trend’s movement. At times the secondary trend can fully retrace the preceding movement but it often stops at 1/2 or 2/3 of the preceding movement. - Minor trend.
This is the day-to-day fluctuation trend and will usually last from a few hours to weeks. It is not given any importance in Dow Theory.
3. Primary trends have three phases.
The three phases of a bull market are:
- Accumulation phase.
Smart money is accumulating assets at low prices during this phase. Economic news is often at its worst. - Public participation phase.
Increased trading volume and prices rise during this phase. It draws the attention of retail and average investors. This is generally the longest and most profitable phase. - Excess phase.
The market becomes over-bought during this phase. Smart money and experienced traders are exiting their positions, while more retail and inexperienced traders are drawn to the market.
The three phases of a bear market are:
- Distribution phase.
Smart money bought during the accumulation phase begins to start taking profits by selling their assets during this phase. Trading volume is still high but is starting to decrease. - Public participation phase.
Increased trading volume and prices fall during this phase. Retail and average investors are selling to reduce losses. Again, this is generally the longest phase. - Panic phase.
Selling volume reaches a climax during this phase, as from a lack of buyers, the price capitulates and drops rapidly. This phase is usually followed by a long secondary trend, or sideways movement, as the market recovers.
4. Indices must confirm each other.
Dow stated that, for a valid trend to be established, the two indices or market averages 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.
This principle is outdated and does not apply to the cryptocurrency market. However there is a correlation between the stock market and the crypto market and we can use indices like the S&P 500, FTSE 100, or NASDAQ 100 to help determine the market’s direction.
5. Volume confirms the trend.
Volume generally increases if the price is moving in the direction of the primary trend. Volume should decrease if the price is moving against the direction of the primary trend.
If the primary trend is up:
If the primary trend is down:
6. Trends continue until a clear reversal occurs.
Dow stated that a trend continues until a clear reversal is signaled by both the Industrials and Transports indices. This is when the odds of the new trend continuing are at their greatest.
Again, both the Industrials and Transports indices do not apply to the cryptocurrency market. However, we can use indices like the S&P 500, FTSE 100, or NASDAQ 100 to help determine the market’s direction.
References
- Hayes, A. (2022). Dow Theory Explained: What It Is and How It Works. Retrieved 8 January, 2023, from: https://www.investopedia.com/terms/d/dowtheory.asp [↩]
- babypips. (2023). Dow Theory. Retrieved 8 January, 2023, from: https://www.babypips.com/forexpedia/dow-theory#:~:text=The%20Dow%20Theory%20holds%20that,unimportant%20and%20can%20be%20misleading [↩]
