What is Dow Theory?
Dow theory, which is based on Charles Doe’s market theory writings, is basically the basis of technical analysis. Dow was co-founder and editor of Dow Jones and Wall Street Journal. He was part of the company that helped to create the Dow Jones Transportation Index (DJT) and the Dow Jones Industrial Averages (DJIA).
Dow did not write his ideas as a theory, nor did he treat them that way. Many learned from Dow’s Wall Street Journal editorials. William Hamilton, another editor, took his ideas and made them into the Dow Theory.
The Basic Principles of Dow Theory
Everything is reflected in the market
This principle is closely linked to the Efficient Market Hypothesis. Dow believed that the market was throwing everything off. This means that all information available is already being reflected in the price.
If a company expects to report a positive increase in earnings, then the market will reflect it before it actually happens. The market will demand their shares before the report is published. However, the price of the shares may not rise much once the positive report is released.
The Dow noticed in some cases that the stock price may drop after receiving good news. This could be because the news wasn’t as good or expected.
This principle still applies to investors and traders, particularly those who heavily use technical analysis. Fundamental analysts disagree and believe that the stock’s intrinsic value is not affected by its market value.
Some believe that the Dows’ work helped to create the notion of a market trend. This concept is now an integral part of the financial world. According to Dow theory there are three types of market trends.
- This represents the principal movement of the market and can last from several months up to many years.
- Secondary trend Lasts from weeks to many months
- Tertiary trend. usually dies in less that a week, or no more than ten. They can sometimes last for a few hours, or even a day.
Investors can identify opportunities by studying these trends. Opportunities can arise when the primary trend seems to be contradictory.
If you believe a cryptocurrency is in a positive primary trend but has a negative secondary trend, it may be possible to purchase it at a low price and then try to sell it as soon as it increases in value.
As always, the challenge is to identify what kind of trend you are seeing. This is where technical analysis comes in handy.
There are three phases to major trends
Dow discovered that long-term underlying trends can be divided into three phases. Here are some examples of the bull market phases:
- Asset valuations remain low after the previous bear markets, as market sentiment remains overwhelmingly negative. Market makers and smart traders begin to accumulate in this period, before there is an increase in price.
- Public participation Smart traders are now seeing the potential, and the broad market is taking advantage of it. The population is also becoming more active in shopping. Prices tend to rise quickly at this stage.
- The third stage continues speculation, but the trend is nearing its end. Market makers are now beginning to sell their assets to other participants, which is a way to get ahead of the curve.
The phases would swap places in a bear market. The trend will begin with the recognition of signs and spread to others. Public participation will follow. The public will continue to be discouraged, but investors who see the shift in the future will start to accumulate again.
Although the principle may not be true, thousands of investors and traders consider each stage before making any decisions. Wyckoff’s method, which also uses the ideas of accumulation & distribution, describes a similar concept of market cycles (the transition between one phase and another).
Dow believes that main trends in one market index must be confirmed by trends in another. This was mainly the Dow Jones Transportation Index, and the Dow Jones Industrial Average.
The transportation market, mainly railways, was closely linked to production activities at that time. This is understandable. To produce more goods, it was important to first increase the railway activity to supply the raw materials.
There is a strong correlation between the transportation market and the manufacturing industry. One would be healthier than the other if it were. Cross-index correlation is not possible today because many goods can be delivered digitally and are not physically required.
Volume is important
The Dow, like many investors, believed that volume was an important secondary indicator. This meant that strong trends must be accompanied with large trading volumes. The more volume the movement is likely to reflect the true market trend, the higher it will be. If the volume of trading is low, price action might not reflect true market trends.
Trends will be valid up to the confirmation of a reversal
Dow believed that the market would continue to trend if it is in a trend. For example, a stock that is commercial will start an uptrend following positive news and it will continue doing so until the trend reverses.
The Dow believed that reversals should not be taken seriously until they are confirmed as an underlying trend. It is difficult to distinguish a secondary trend and a primary trend. Traders often come across misleading reversals, which can end up being secondary trends.
Some critics claim that Dow’s theory has become outdated, particularly in regard to cross-index correlation. This principle states that one index or average should support the other. However, investors still find the Dow theory to be relevant today. It is not only about the definition of financial opportunities but also the concept of market trends that dows create.