Table of contents

  • What is Dow Theory?

  • The Basics of Dow Theory

    • The market reflects everything

    • Market Trends

    • The three stages of a primary trend

    • Cross-index correlation

    • Volume matters

    • The trend remains in effect until a reversal occurs.

  • Summarize


What is Dow Theory?

Essentially, the Dow Theory is a framework for technical analysis based on the work of Charles Dow on market theory. Dow was the founder and editor of The Wall Street Journal and co-founder of Dow Jones & Company. As part of the company, he helped create the first stock index, called the Dow Jones Transportation Average (DJT), followed by the Dow Jones Industrial Average (DJIA).

Dow never wrote down his ideas as a specific theory or referred to them in that way. Despite this, many people learned from him through his editorials in the Wall Street Journal. After Dow's death, other editors such as William Hamilton refined these ideas and put his editorials together, which is now known as "Dow Theory".

This article will introduce the Dow Theory in detail and discuss the different stages of market trends based on Dow Jones's results. As with other theories, the principles described below are not absolutely feasible and are only intended for public interpretation.

 

The Basics of Dow Theory

The market reflects everything

This principle is closely related to the so-called efficient market hypothesis (EMH). Dow believed that markets are reflective, meaning that all available information is already reflected in prices.

For example, if a company is widely expected to report earnings, the market will reflect this before the company actually releases its earnings report. The demand for the stock will increase before the company reports, and then the price may not change much after the expected positive report is finally released.

Dow noted that in some cases, a company may see its stock price fall after earnings because it performs below expectations.

Many traders and investors, especially those who make extensive use of technical analysis, still believe this principle to be correct. However, those who prefer fundamental analysis disagree and believe that market value does not reflect the intrinsic value of a stock.

 

Some say that Dow's work gave rise to the concept of market trends, which are now considered an important part of the financial world. Dow Theory states that there are three main types of market trends:

  • Primary Trend – Lasting from months to years, this is the most important market movement.

  • Secondary Trends – last from weeks to months.

  • Short-term trends – tend to end in less than a week or no more than ten days. In some cases, they may last only a few hours or a day.

By studying these different trends, investors can look for opportunities. While the primary trend is the one to prioritize and focus on, profit opportunities often arise when secondary and short-term trends move in the opposite direction of the primary trend.

For example, if you believe that the primary trend of a cryptocurrency is upwards, and the secondary trend is downwards, there may be an opportunity to buy it at a relatively low price and try to sell it after it has increased in value.

The problem now is identifying exactly what type of trend you are looking at, which is where the more in-depth technical analysis comes in. Today, investors and traders use a variety of analysis tools to help them identify the type of trend they are looking at.

 

The three stages of a primary trend

Dow divided long-term major trends into three phases. For example, in a bull market, the three phases would be:

  • Accumulation – After the previous bear market, market sentiment is mainly negative and asset valuations remain low. Smart traders and market makers accumulate assets during this period before prices rise significantly.

  • Large retail participation – At this stage, the market will achieve more rapid growth, as a large number of retail traders begin to actively buy, just as the savvy traders have observed the opportunity before. At this stage, the price will rise rapidly.

  • Excess and Distribution – In the third stage, most traders continue to buy, but in reality, the uptrend is nearing its end. Market makers start to sell off their holdings by selling shares to other participants who have not yet realized that the uptrend is about to change.

In a bear market, these stages are exactly the opposite. The trend will start with a sell signal, followed by a large number of retail investors participating in the sell. In the third stage, retail investors will continue to be pessimistic, but investors who can recognize that the market is about to turn will start to accumulate again.

There is no guarantee that the principle will apply, but thousands of traders and investors consider these stages before taking action. It is worth noting that the Wyckoff theory is also based on the ideas of accumulation and distribution, describing a similar concept of market cycles (transitions from one stage to another).

 

Cross-index correlation

Dow believed that a major trend in one market index could be confirmed by a trend in another market index. At the time, this primarily involved the Dow Jones Transportation Average and the Dow Jones Industrial Average.

At the time, the transportation market (mainly railroads) was closely tied to industrial activity. This made sense: to produce more goods, you first needed to increase railroad activity to provide the necessary raw materials.

Therefore, there is an obvious correlation between the manufacturing and transportation markets. If one is healthy, the other is likely to be healthy as well. However, since many goods are digital and do not require physical delivery, the principle of cross-index correlation is not used much today.

 

Volume matters

As is the case with most investors, Dow believed that volume was a key secondary indicator, meaning that strong trends should be accompanied by volume. The greater the volume, the more likely that the move reflects the true trend of the market. When volume is low, price action may not represent the true market trend.

 

The trend remains in effect until a reversal occurs.

Dow believed that if the market showed a trend, it would continue to run in that trend. For example, a company's stock began to rise after good news, and the stock price would continue to rise until there was a clear reversal signal.

Therefore, Dow believes that before confirming the emergence of the main trend, one should be skeptical of the current reversal trend. Of course, it is not easy to distinguish the signals of the occurrence of secondary trends and primary trends. Traders are often disturbed by misleading reversal signals and eventually find that they are only signals of secondary trends.

 

Summarize

Some believe that Dow Theory is obsolete, especially in regards to cross-index correlations (the principle that one index or average can be supported by another index). Despite this, most investors still believe that Dow Theory is relevant to today's markets. Dow's work can not only be used to find trading opportunities, but also created the concept of market trends.