{“content”:"## What is the Dow Theory?
The Dow Theory is a pivotal financial concept that suggests the stock market is in an upward trend if one of its major averages (like industrials or transportation) surpasses a previous high, especially if followed by a similar surge in another average. For instance, if the Dow Jones Industrial Average (DJIA) reaches an intermediate high, an investor might look for the Dow Jones Transportation Average (DJTA) to climb as confirmation of an upward trend.
Key Takeaways
- The Dow Theory forms a framework to forecast market trends, asserting upward momentum when one average passes a significant high, followed by another.
- It operates on the efficient market hypothesis principle, indicating that market prices encode all available information.
- The theory insists different market indices corroborate each other in price and volume trends until a trend reversal appears.
Understanding the Dow Theory
Origin and Evolution
The Dow Theory arose from the trading principles conceived by Charles H. Dow, who, along with Edward Jones and Charles Bergstresser, founded Dow Jones & Company, Inc., and fashioned the DJIA in 1896. Despite Dow passing away in 1902 before publishing his complete market theory, his editorials laid the groundwork. Various followers expanded on Dow\u2019s insights, major contributors include:
- William P. Hamilton’s The Stock Market Barometer (1922)
- Robert Rhea’s The Dow Theory (1932)
- E. George Schaefer’s How I Helped More Than 10,000 Investors to Profit in Stocks (1960)
- Richard Russell’s The Dow Theory Today (1961)
Dow postulated that the stock market reflects the business conditions in the economy, making the overall market’s analysis reliable for projecting significant market trends and determining individual stock directions. Though times have changed certain sectors, Dow’s fundamental principles remain essential to modern technical analysis.
Components of the Dow Theory
1. The Market Discounts Everything
The Dow Theory relies on the efficient market hypothesis, emphasizing that asset prices integrate all available information - even future events are somewhat factored as risks. This holistic view sees all pertinent aspects, like earnings potential and management expertise, reflective in stock prices.
2. Three Types of Market Trends
Markets exhibit primary trends (lasting a year or more, such as bull or bear markets), secondary trends (smaller fluctuations within the primary trend, lasting weeks to months), and minor trends (day-to-day variations considered market noise).
3. Phases of Primary Trends
Bull Markets undergo three phases:
- Accumulation Phase: Prices begin to rise with volume.
- Public Participation (or Big Move) Phase: Retail investors recognize and join the rise - typically the longest phase.
- Excess Phase: Savvy investors exit, but average investors continue to invest.
Bear Markets mirror these phases in reverse:
- Distribution Phase: Insider news of decline spreads.
- Public Participation Phase: Retail investors sell-off, typically the longest duration.
- Panic Phase: Mass sell-off as hope diminishes.
4. Index Confirmation
Dow’s principle insists various indices must corroborate each other\u2019s trends. Signals of uptrends or downtrends from one index, like DJIA, must be mirrored by counterparts like DJTA, emphasizing holistic economic health.
5. Volume Confirmation
A trend’s strength is confirmed through trading volume \u2013 higher volumes during trend-consistent moves reflect strength, whereas low volumes during opposing moves suggest trend weakness. Increased volume during secondary pullbacks in a bull market indicates continuing trader confidence.
6. Trends Persist Until Clear Reversals
Primary trend reversals are delicate to ascertain. Dow’s methodology recommends cautious confirmation from corresponding indices, as initial reversal signs could be mistaken for transient secondary trends.
Special Considerations and Practical Usage
Closing Prices and Line Ranges
Dow prioritized closing prices over intraday fluctuations, considering them more reflective of market sentiment. ‘Line ranges’ or periods of horizontal price stagnation are viewed as consolidation phases, awaiting eventual breakout determines subsequent market movement.
Detecting Reversals
Reversal identification, essential for Dow adherents, uses peak-and-trough analysis - successive higher peaks and troughs suggest an uptrend, while lower peaks and troughs indicate a downtrend. Reversal assurance comes from confirmed pattern deviations.
Driving Factors and Evolution
Factors Influencing Trends
Influences include the economy-wide impact factors for stocks comprising indices like the DJIA. Trends derive from comprehensive market-participant sentiment informed by broad economic indices.
Goal and Practical Utility for Investors
Ultimately, the Dow Theory helps investors pinpoint the market’s primary trend through collaborative index performance, trend phases, volume confirmations, and avoidance of secondary trend confusions \u2013 aiding informed and strategic market participation.
Related Terms: Efficient Market Hypothesis, Technical Analysis, Market Trends, Dow Jones Industrial Average.
References
- The Wall Street Journal. “The Beginning: 1882-1899”.
