Dow Theory is a set of principles that help investors analyse and predict market trends.
It
was developed by Charles H. Dow, the co-founder of Dow Jones & Company, in the late
19th century. Dow Theory is one of the foundational theories for technical analysis in the
stock market.
Key Principles of Dow Theory:
1. The Market Discounts Everything:
o According to Dow Theory, all information, whether public or private, is
reflected in the price of the stock or market. This includes factors like
economic data, political events, corporate earnings, and other relevant news.
o Hence, prices move in response to new information and the markets always
adjust accordingly.
2. Three Types of Trends: Dow identified three distinct types of trends in the market:
o Primary Trend (Major Trend): This is the long-term trend, lasting for a year
or more. It is the main direction in which the market or stock moves and can
be either an uptrend (bull market) or downtrend (bear market).
o Secondary Trend (Intermediate Trend): This is the medium-term trend that
usually lasts between 3 weeks to 3 months. It often goes against the primary
trend (a correction or pullback). For example, in a bull market, the secondary
trend could be a short-term drop or consolidation.
o Minor Trend (Short-Term Trend): This is the short-term movement that lasts
for a few days to a few weeks. These are considered daily fluctuations in the
market and are less important than the primary and secondary trends.
3. Trends Have Three Phases: Every primary trend (whether up or down) consists of
three phases:
o The Accumulation Phase: This occurs when smart money or experienced
investors begin to buy (in a bull market) or sell (in a bear market) when the
market is not yet showing clear signs of direction. This phase often happens
when market sentiment is negative, and prices are low (for a bull market) or
high (for a bear market).
o The Public Participation Phase: In this phase, more investors start to join the
market, causing an increase in prices. For a bull market, this is when the
general public begins to notice the market is moving upward, leading to
widespread buying. For a bear market, it’s when public sentiment worsens and
more investors sell.
o The Distribution Phase: In this phase, the market reaches its peak (in a bull
market) or bottom (in a bear market). The smart money begins to exit, selling
off their positions, while the public continues to buy into a market that appears
to be continuing in the same direction.
4. The Averages Must Confirm Each Other: According to Dow Theory, the
movements in stock market averages (like the Dow Jones Industrial Average (DJIA)
and the Dow Jones Transportation Average (DJTA)) must confirm each other. For
example, if the DJIA is showing an uptrend, the transportation average must also
confirm this trend by showing an uptrend. If one average is moving in a different
direction than the other, it suggests that the trend may not be valid or could be nearing
a reversal.
5. Volume Confirms the Trend: Volume plays a crucial role in confirming a market
trend. If the market is moving in a certain direction and volume is increasing, it
suggests that the trend is strong and likely to continue. If the market is moving in a
certain direction but volume is declining, it could indicate a lack of support for the
trend and a potential reversal.
6. Trends Persist Until a Clear Reversal Occurs: Dow Theory suggests that trends in
the market tend to persist until they show clear signs of reversal. This means that once
a primary trend is in place, it is likely to continue for an extended period, barring any
strong evidence of a trend change.
Applying Dow Theory in Today’s Market:
Even though Dow’s original work was based on industrial stocks and the transportation
sector, the basic principles of Dow Theory can be applied to modern-day stock markets.
Traders and investors use Dow Theory to identify the direction of major trends and to make
informed decisions based on market behavior.
For instance:
Trend Identification: Dow Theory helps traders determine whether the market is in
an uptrend, downtrend, or sideways.
Confirming Signals: It helps traders confirm that the trend in different sectors or
indices is aligned and not contradictory.
Risk Management: Since Dow Theory also emphasizes the need to wait for a trend
reversal to be confirmed, it helps in managing risk by preventing traders from
jumping in too early.
Criticisms of Dow Theory:
While Dow Theory has been a foundational concept in technical analysis, it does have some
limitations:
1. Subjectivity: Identifying and interpreting market trends is somewhat subjective.
Different analysts may see different things based on the same data.
2. Lagging Indicators: Since Dow Theory relies on confirming trends (which can take
time), it may miss out on opportunities for earlier trades.
3. Over-reliance on Historical Data: Dow Theory focuses heavily on past market data,
which may not always reflect future market conditions or new market dynamics.
4. Focus on Averages: In the modern market, the use of indices like the DJIA and
DJTA has decreased, and the relevance of averages has come into question.
Conclusion:
Dow Theory provides a framework for understanding the movements of stock markets and
trends. By focusing on the behavior of markets over time, it helps investors identify long-
term market movements, understand the phases of trends, and recognize when a trend is
likely to reverse. While it has limitations, it remains an essential tool for technical analysis,
especially when combined with other indicators and market analysis techniques.
