Dow Theory

Dow Theory,It is generally recognized that technical analysis started with the work of Charles H. Dow. This is the same Dow who teamed with Edward Jones, and is still remembered in the name of one of the leading stock market indices, the Dow Jones Industrial Average (DJIA).

Dow and Jones founded their business, Dow Jones & Co., in 1882. They started by distributing a small handwritten newsletter to banks and brokerages. It was called the Customer‘s Afternoon Letter. It became the Wall Street Journal in 1889, and Dow continued as its editor. Dow was fascinated by the markets, and wrote many articles about them. He chose to measure the health of the economy by putting together an average of stock values in 1884. This average included nine railroad shares in a selection of 11 stocks. To Dow, the stock market was a barometer that would indicate the state of business.

In 1896, Dow decided to split transportation stocks and industrial stocks, and so the DJIA and the Dow Jones Transportation Average (DJTA) were created. The DJIA originally included 12 stocks and the DJTA had 20. In those days, transportation meant the railroads. Dow showed remarkable insight in recognizing the importance of following individual sectors.

Dow was a student of the interaction between the industrial and the transportation companies, and one of his basic doctrines was -What one makes, the other takes‘. In other words, if industry is doing well and increasing production, then transportation shares should also rise as the railroads would be moving more goods to the consumer. This idea is included in the six basic tenets that are now known as the Dow Theory.

Other factors that Dow pointed out about the performance of stocks and shares were that share prices tend to move in trends for much of the time, that there were sometimes secondary trends countering the main direction, and that trends tended to continue until a major force acted to stop them. You may recognize that the secondary trends are the same thing as what we called retracements earlier.

                          The Basic Principles of Dow Theory

You‘ll find that the principles that Dow discovered are still considered valid and useful. As much work as has been done on technical analysis in more than 100 years, the basics still apply. Here are the six principles that were compiled from his essays.

1. The averages reflect everything that can be known about a price. This should sound familiar, as it is merely stating the first tenet of technical analysis given above, as applied to averages. Even when unknowable events such as natural catastrophes occur, the markets will move quickly to assimilate the events into the prices.

2. The markets exhibit three types of movement. The primary movement or trend lasts from a year to 28 to 33 months or longer. The secondary movement lasts from three weeks to three months, and is a retracement of 1/3 to 2/3 of the primary trend. The third movement is a minor trend, which represents a fluctuation which lasts less than three weeks.

3. Primary movements have three phases. Dow identified three distinct types of buying (or selling, in a bear market) during a major trend. These are discussed in greater detail below.

4. It takes both the DJIA and the DJTA to confirm a trend. This tenet was mentioned above. Dow did not consider a trend to be established unless both the industrial and transport averages were moving in concert. Similarly, he considered the current trend continuing until both of the averages reversed. This confirmation did not have to happen on the same day, but the confirmation is considered stronger the closer together the two signals are. If the averages did not agree, the prior trend was still valid.

5. Volume should increase in the direction of the trend to give confirmation. Dow recognized the importance of volume in confirming the strength of a trend. While a secondary indication, if the volume did not increase in the direction of the trend, this was a warning sign that the trend may not be valid.

6. A trend continues until a clear reversal. The opposite view to the Random Walk Theory, this tenet is the basis of many trading strategies to this day.

You can see the types of movement mentioned in point 2 in the previous figure, which showed it in a simple form. The price makes a run, only to run out of breath, as it were, and sag back a little. If the trend is good, after a little rest the price resumes its trend, going further than it got to last time before the next retracement. Now you have the concept, here are a couple of real charts showing the principles.

                          Focus on when up trend / up movement 

                          Focus on when downtrend / down movement 

                          Dow Theory Criticism

While much of what Dow wrote can be recognized in some form in modern-day technical analysis, it has inevitably been criticized in the light of later thinking. Considering that Charles Dow made his observations more than 100 years ago, it perhaps should be considered more astonishing that so much of his work is still recognizable in modern times.

The first point is that Dow relied on closing prices only. He used a simple line chart, such as I‘ve included here to illustrate the principles, and only based his interpretation of the trends on these values. You will see in the next module, on charting, that we do have more information than that, which can help us interpret the mood of the market. As prices can vary significantly during the day, or ‗intraday‘, this can affect the accuracy of the trends.

Secondly, by the time that Dow‘s criteria have indicated a bull or bear market, possibly a quarter or a third of the price move may already have happened. Usually the confirmed signal will be in the second phase of the trend. This is no worse than many trend following systems, but obviously the trader would like to improve on it to increase potential profits.

Another point is that the averages such as Dow used are not much use to shorter term investors who seek to profit in less than a year. The Dow Theory, at its core, provides analysis and explanation of the market movements over a 2 to 3 year period. While the concepts are useful in developing technical analysis tools, the tenets of the theory relate more to an investing rather than trading timescale.

Perhaps the most important lesson to be taken from the Dow Theory is that Dow looked at what is happening in the markets, rather than what ‗should be‘. His tenets were based on his observations. Many a beginning trader has cried ‗Foul!‘ when a stock price has moved in the opposite direction to where it ‗ought to‘ by a process of reason. The markets will do what they want, and have no knowledge of reasonable expectations. It is up to the trader to interpret what is actually happening in order to gain an indication of the future.

The principles that Dow put forth are still talked about by traders. If you know them, you have very sound basis from which to develop and learn more about technical analysis. There is nothing controversial here, but learning them is a good start to your trading education.