The Dow theory is a theory that says the market is in an upward trend if one of its averages (industrial or transportation) advances above a previous important high and is accompanied or followed by a similar advance in the other average. For example, if the Dow Jones Industrial Average (DJIA) climbs to an intermediate high, the Dow Jones Transportation Average (DJTA) is expected to follow suit within a reasonable period of time.
The Dow theory is an approach to trading developed by Charles H. Dow who, with Edward Jones and Charles Bergstresser, founded Dow Jones & Company, Inc. and developed the DJIA. Dow fleshed out the theory in a series of editorials in the Wall Street Journal, which he co-founded.
Charles Dow died in 1902, and due to his death, he never published his complete theory on the markets, but several followers and associates have published works that have expanded on the editorials.
Dow believed that the stock market as a whole was a reliable measure of overall business conditions within the economy and that by analyzing the overall market, one could accurately gauge those conditions and identify the direction of major market trends and the likely direction of individual stocks.
The theory has undergone further developments in its 100-plus-year history, including contributions by William Hamilton in the 1920s, Robert Rhea in the 1930s, and E. George Shaefer and Richard Russell in the 1960s. Aspects of the theory have lost ground, for example, its emphasis on the transportation sector — or railroads, in its original form — but Dow’s approach still forms the core of modern technical analysis.
The market discounts all news
This principle explains that any information available in the market is already reflected in the price of stocks and indices. This includes all data such as earnings announcements by companies, rise (or fall) in inflation or even sentiments of investors.
As a result, it is better to analyse price movements instead of studying earnings reports or balance sheets of companies.
The market has three trends
This theory was the first to propound that the market moves in trends. The trends are:
Primary trend is the major trend for the market. It indicates how the market moves in the long-term. A primary trend could span many years.
Secondary trends are considered to be corrections to a primary trend. This is like an opposite movement to the primary trend. For example, if the primary trend is upward (bullish), the secondary trend(s) is downward. These trends could last anywhere between a few weeks to a few months.
Minor trends are fluctuations to the market movement on a daily basis. These trends last for less than three weeks and go against the movement of the secondary trend. Some analysts consider minor trends to mirror market chatter.
Trends have three phases
The theory says that there are three phases to each primary trend: accumulation phase, public participation phase and panic phase.
The beginning of a primary upward (or downward) trend in a bull (or bear) market is known as the accumulation phase. Here, traders enter the market to buy (or sell) stocks against common market opinions.
In the public participation phase, more investors enter the market as business conditions improve and positive sentiments become evident. This results in higher (or lower) prices in the market.
The panic phase is marked by excessive buying by investors. This could result in great speculation. At this stage, it is ideal for investors to book profits and exit.
Indices confirm each other
A trend in the market cannot be verified by a single index. All indices should reflect the same opinion. For example, in case of a bullish trend in India, the Nifty, Sensex, Nifty Midcap, Nifty Smallcap and other indices should move in the upward direction. Similarly, for a bearish trend, all indices should move in a downward direction.
Trends are confirmed by volume
The trend in the market should be supported by trading volumes. For instance, in an upward trend, the volume rises with increase in price and falls with decrease in price. And in a downward trend, the volume increases with fall in price and decreases with price rise.
Trends continue until definitive signals indicate otherwise
The theory says that market trends exist despite any noise in the market. That is, during an upward trend, a temporary trend reversal is possible but the market continues to move in the upward direction. In addition, the status quo remains until a clear reversal happens in the market.