Dow Theory is a fundamental theory of technical analysis that was developed by Charles H. Dow, the founder of Dow Jones & Company and the creator of the Dow Jones Industrial Average. The theory is based on the analysis of market trends and is used to identify long-term market trends, predict market movements, and make investment decisions.
The theory is based on six basic tenets, which we will discuss in detail below:
- The market reflects all available information
- The market moves in trends
- Trends have three phases
- Trends are confirmed by market indexes
- The average must confirm each other
- Volume should confirm the trend
The market reflects all available information
The first tenet of Dow Theory is that the market reflects all available information. This means that market prices already reflect all the available information about a company, including its financial statements, news releases, and other public information. In other words, the market is efficient and is not easily influenced by new information or rumors.
The market moves in Trends
The second tenet of Dow Theory is that the market moves in trends. A trend is defined as a long-term movement of market prices in a particular direction. Dow believed that market trends could last for several months or even years and that they could be identified by analyzing price charts.
There are three types of market trends:
- Primary trend: A primary trend is the major, long-term movement of the market. It can last from several months to several years and reflects the overall direction of the market. A primary trend can be either bullish (upward) or bearish (downward).
- Secondary trend: A secondary trend is a shorter-term movement within the primary trend. It can last from several weeks to several months and reflects a temporary reversal in the primary trend. A secondary trend can be either bullish or bearish.
- Minor trend: A minor trend is a short-term movement within the secondary trend. It can last from several days to several weeks and reflects minor fluctuations in the market.
Trends have three phases
The third tenet of Dow Theory is that trends have three phases. These phases are:
- Accumulation phase: The accumulation phase occurs when investors start buying stocks that they believe are undervalued. This phase typically occurs after a bear market, and investors are trying to identify stocks that have the potential to increase in value.
- Public participation phase: The public participation phase occurs when the general public starts to take notice of the market trend and starts buying stocks. This phase is characterized by increasing volume and rising prices.
- Distribution phase: The distribution phase occurs when investors who have profited from the market trend start to sell their stocks. This phase is characterized by decreasing volume and declining prices.
Trends are confirmed by market indexes
The fourth tenet of Dow Theory is that trends are confirmed by market indexes. Dow believed that the overall market trend could be confirmed by analyzing the performance of market indexes such as the Dow Jones Industrial Average and the Dow Jones Transportation Average.
According to Dow Theory, if both indexes are moving in the same direction, it confirms the current market trend. For example, if both indexes are rising, it indicates a bullish trend, and if both indexes are falling, it indicates a bearish trend.
The averages must confirm each other
The fifth tenet of Dow Theory is that the averages must confirm each other. This means that for a trend to be considered valid, both the Dow Jones Industrial Average and the Dow Jones Transportation Average must be moving in the same direction.
According to Dow Theory, if the two averages are moving in opposite directions, it indicates a non-confirmation, and the market is considered to be in a state of flux. In this situation, investors should be cautious and wait for further confirmation before making investment decisions.
Volume should confirm the trend
The final tenet of Dow Theory is that volume should confirm the trend. Dow believed that the volume of trading is an important indicator of market trends and that increasing volume should confirm the direction of the trend.
For example, if the market is in a bullish trend, increasing volume should be seen as investors buy more shares and push prices higher. Similarly, in a bearish trend, increasing volume should indicate that investors are selling their shares and pushing prices lower.
Applications of Dow Theory
Dow Theory has several practical applications in technical analysis and investment decision-making. Some of these include:
- Trend identification: Dow Theory can be used to identify long-term market trends and predict future market movements. By analyzing price charts and market indexes, investors can identify primary and secondary trends and make investment decisions accordingly.
- Confirmation of trends: Dow Theory can be used to confirm the validity of market trends by analyzing the performance of market indexes and the volume of trading. This can help investors make more informed investment decisions and avoid false signals.
- Risk management: Dow Theory can be used as part of a risk management strategy by helping investors identify when to exit a position. By monitoring market trends and analyzing the performance of market indexes and volume of trading, investors can identify when a trend is changing direction and exit a position before suffering significant losses.
Limitations of Dow Theory
While Dow Theory has been a popular and influential theory of technical analysis, it has several limitations and criticisms. Some of these include:
- Lack of specific guidelines: Dow Theory provides a broad framework for analyzing market trends but does not provide specific guidelines for making investment decisions. Investors must rely on their own judgment and experience to apply the theory effectively.
- Limited scope: Dow Theory focuses primarily on long-term market trends and does not provide guidance for analyzing short-term market movements. This can limit its usefulness for investors who are looking to make short-term trades or who are focused on specific sectors or industries.
- Subjectivity: Dow Theory relies on the interpretation of market data and can be subject to individual biases and interpretations. This can lead to different investors reaching different conclusions based on the same data.
- Lack of empirical evidence: While Dow Theory has been widely used and influential in technical analysis, there is limited empirical evidence to support its effectiveness. Some studies have found that Dow Theory signals are no better than random chance in predicting market movements.