DOW Theory

Dow Theory is a set of principles for analyzing stock market movements developed by Charles Dow, co-founder of Dow Jones & Company and the first editor of The Wall Street Journal. This theory is based on Dow’s editorials and was later formalized by William Hamilton and Robert Rhea. Dow Theory suggests that the stock market moves in identifiable long-term trends which are confirmed by the performance of the Dow Jones Industrial and Dow Jones Transportation averages. It outlines three primary movements: the main movement (major trend), the medium swing (secondary reaction), and the short movement (daily fluctuations). Dow Theory also emphasizes that volume should confirm trends, with volume increasing in the direction of the primary trend. It remains a foundational concept for modern technical analysis, helping investors to predict potential market trends based on historical price movements.

Dow Theory Principles:

Dow Theory, developed from the writings of Charles Dow, founder of The Wall Street Journal and co-founder of Dow Jones & Company, offers a framework for technical analysis and a method for studying market movements.

1. The Market Has Three Movements:

   • Primary movements are major trends that last a year or more and represent the broad underlying market direction.

   • Secondary movements are corrective phases within the primary trend, lasting from a few weeks to a few months.

   • Minor movements are short-term fluctuations that are often just noise within the secondary movements.

2. Market Trends Have Three Phases:

   • Accumulation Phase: The knowledgeable investors start buying or selling, anticipating new market directions.

   • Public Participation Phase: The majority of investors catch on and begin following the new trend.

   • Distribution Phase: Knowledgeable investors start to close their positions as the market peaks or bottoms out.

3. The Stock Market Discounts All News:

Stock prices quickly incorporate and reflect all available information, meaning the market price is influenced by future expectations and all known information.

4. Indexes Must Confirm Each Other:

For a trend to be established, major indexes, particularly industrials and transports as per Dow’s time, must confirm each other. For example, if one index reaches a new high or low, the other must soon follow for a true trend confirmation.

5. Volume Must Confirm the Trend:

Volume should increase when the price moves in the direction of the trend and decrease during counter-trend moves. This serves as a confirmation that the prevailing trend is supported by the market.

6. Trends Continue Until Definitive Signals Prove That They Have Ended:

Trend in motion is presumed to be in effect until clear and definitive signals prove that it has reversed. This principle underscores the importance of staying with the trend until significant evidence suggests it has ended.

Failure Swing

The failure of the peak at C to overcome A, followed by the violation of the low at B, constitutes a “sell” signal at S.

Nonfailure Swing

Notice that C exceeds A before D falling below B. Some Dow theorists would see a “sell” signal at S1, while others would need to see a lower high at E before turning bearish at S2.

Dow only took in consideration closing prices. Averages had to close higher than a previous peak or lower than a previous trough to be significant. Intraday penetrations did not count.

Failure Swing Bottom

The “buy” signal takes place when point B is exceeded (at Bl).

Nonfailure Swing Bottom

“Buy” signals occur at points B1 or B2.