What is Dow Theory?

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

Dow never wrote his ideas down as a specific theory or referred to them as such. However, many learned from him through his editorials in the Wall Street Journal. After his death, other editors, such as William Hamilton, refined these ideas and used his editorials to compile what is now known as "Dow Theory."

This article provides an introduction to Dow Theory, and discusses the different stages of market trends based on Dow's work. As with any theory, the following principles are not infallible and open to interpretation.

 

Basic principles of Dow Theory

The market reflects everything

This principle is closely aligned with the so-called efficient market hypothesis (EMH). Dow believed that the market captures everything, meaning that all available information is already reflected in the price.

For example, if a company is widely expected to report positive improving earnings, the market will reflect that before it happens. Demand for the company's shares will increase before the report is released, so the price may not change much after the expected positive report is finally released.

In some cases, Dow notes that a company may see a decline in its stock price after good news because it was not as good as expected.

This principle is believed by a number of traders and investors to be correct, especially by those who use technical analysis extensively. However, those who prefer fundamental analysis do not agree with this principle and believe that market capitalization does not reflect the intrinsic value of a stock.

 

Some people say that it was Dow's work that gave birth to the concept of market trend, which is now considered a staple of the financial world. Dow Theory says that there are three main types of market trends:

  • Primary trend – lasts from months to many years, and represents a major market movement.

  • Secondary trend – lasts from weeks to a few months.

  • Post-secondary trend – tends to decline in less than a week or no more than ten days. In some cases, it may last for only a few hours or a day.

By studying these different trends, investors can find opportunities. While the primary trend is the one to consider primarily, favorable opportunities tend to occur when secondary and post-secondary trends appear to conflict with the primary trend.

For example, if you believe that a cryptocurrency has a positive primary trend, but is experiencing a negative secondary trend, there may be an opportunity to buy it at a relatively low price, and try to sell it once its value increases.

The problem now, as then, is to recognize what type of trend you are observing, and this is where deeper technical analysis comes into play. These days, investors and traders use a wide range of analytical tools to help them understand what type of trend they are looking for.

 

Dow demonstrated that long-term fundamental trends have three phases. For example, in a bull market the stages are:

  • Aggregation – After the previous bear market, asset valuation remains low as market trends are mostly negative. Smart traders and market makers start accumulating during this period, before a significant price increase occurs.

  • Public Participation – The broader market now recognizes the opportunity that savvy traders have already noticed, and the general public becomes increasingly active in buying. During this stage, prices tend to increase rapidly.

  • Expansion and Distribution – In the third stage, the general public continues to speculate, but the trend is coming to an end. Market makers begin distributing their balances, i.e. by selling to other participants who have not yet realized that the trend is about to reverse.

In a bear market, the phases are essentially reversed. The trend starts with distribution from those who are aware of the signs, and then public participation follows. In the third stage, the general public despairs, but investors who can see the coming shift will start accumulating again.

There is no guarantee that this principle will remain true, but thousands of traders and investors think through these stages before taking action. Notably, the Wyckoff method also builds on the ideas of aggregation and distribution, and describes a somewhat similar concept to market cycles (movement from one phase to another).

 

Cross indicator correlation

Dow believed that the fundamental trends we see in one market index should be confirmed by trends seen in another market index. At the time, this was mainly for the Dow Jones Transportation Index and the Dow Jones Industrial Average.

Also at that time, the transportation market (mainly railways) was closely linked to industrial activity. This makes sense: to produce more goods, increased railway activity was first needed to provide the necessary raw materials.

As such, there was a clear connection between the manufacturing sector and the transportation market. If one is in good condition, the other probably will be as well. However, the principle of cross-index correlation does not hold up well today because many goods are digital and do not require physical delivery.

 

Size matters

As many investors do now, Dow believes in volume as a crucial secondary indicator, meaning that a strong trend must be accompanied by high trading volume. The higher the volume, the more likely it is that the movement reflects the true direction of the market. When trading volume is low, price action may not represent the true market trend.

 

Dow believed that if the market was hot, it would continue in that direction. So, for example, if a company's stock starts trending upward after positive news, it will continue in that trend until a clear reversal appears.

For this reason, Dow believed that reversals should be treated with caution until they are confirmed as a new fundamental trend. Of course, distinguishing between a secondary trend and the beginning of a new primary trend is not easy, and traders often encounter misleading reversals that end up being merely secondary trends.

 

Concluding thoughts

Some critics argue that Dow Theory is outdated, especially with regard to the principle of cross-index correlation (which states that one index or average must support another index or average). However, most investors consider Dow Theory relevant today, not only because it relates to identifying financial opportunities, but also because of the concept of market trends that resulted from Dow's work.