What is Dow Theory?

Basically, Dow Theory is a framework for technical analysis that is based on Charles Dow's studies of market theories. Dow was the founder and publisher of the Wall Street Journal and co-founder of Dow Jones & Company. As a member of the firm, 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, nor did he refer to them as such. Still, many learned from him through his publications in the Wall Street Journal. After his death, other editors, such as William Hamilton, refined these ideas and used his editorials to create what is now known as the Dow Theory.

This article provides an introduction to Dow Theory, discussing the different stages of market trends based on Dow's work. As with any theory, the following principles are not infallible and are 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 claimed that the market discounts everything, meaning that all available information is already being reflected in the current price.

For example, if a company is expected to report an increase in earnings, the market will reflect this before it happens. Demand for its shares will increase before the report is published or released, and so the price may not change much after the positive report is finally released.

In some cases, Dow noted, a company may see its stock price fall after good news because it was not actually as good as expected.

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

 

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

  • Primary trend – Lasting from months to many years, this is the main movement of the market.

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

  • Tertiary tendency – Tends to be extinguished in less than a week or up to ten days. In some cases, they may last only a few hours or a day.

By examining these different trends, investors can find opportunities. While the primary trend is the main one to consider, favorable opportunities tend to arise when secondary and tertiary trends appear to contradict the primary one.

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

The trick is recognizing what kind of trend you are observing, and that’s where deeper technical analysis comes in. Today, investors and traders use a wide range of analytical tools to help them understand what kind of trend they are observing.

 

Dow established that long-term primary trends have three phases. For example, in a bull market, the phases would be:

  • Accumulation – After the previous bear market, the value of assets is still low as market sentiment is predominantly negative. Smart traders and market makers start accumulating during this period, before a significant increase in price occurs.

  • Public Participation – The general market now realizes the opportunity that smart traders have already spotted and the public becomes increasingly active in buying. During this phase, prices tend to rise rapidly.

  • Excess and Distribution – In the third phase, the general public continues to speculate, but the trend is coming to an end. Market makers begin to distribute their funds, that is, they begin to sell to other participants who have not yet realized that the trend is about to reverse.

In a bear market, the phases would be reversed. The trend would begin with the distribution of those who interpreted the signals and then the participation of the general public would occur. In the third phase, the public would continue to show signs of despair, but investors capable of predicting the next changes would begin to accumulate again.

There is no guarantee that the principle is true, but thousands of traders and investors consider these phases before acting. The Wyckoff Method is also based on the ideas of accumulation and distribution, describing a similar concept of market cycles (moving from one phase to another).

 

Correlation between indexes

Dow believed that primary trends observed in one market index should be confirmed by trends observed in another market index. At the time, this primarily referred to the Dow Jones Transportation Index and the Dow Jones Industrial Average.

At that time, the transport market (mainly railways) was strongly linked to industrial activity. There was a logic to this: to produce more goods, it was first necessary to increase railway activity to supply the necessary raw materials.

Thus, there was a clear correlation between the manufacturing industry and the transportation market. If one was healthy, the other would probably be healthy too. However, the principle of correlation between indices does not hold up as well today, as there are many digital products that do not depend on physical delivery.

 

Volume matters

As many investors now believe, Dow believed 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 the movement reflects the true market trend. When trading volume is low, the price action may not represent the true market trend.

 

Dow believed that if the market is following a trend, it will continue to do so. For example, if a company's stock starts to rise after the release of good news, the stock will continue to rise until a reversal is definitely apparent.

For this reason, Dow believed that reversals should be treated with some suspicion until they were actually confirmed as a new primary trend. Of course, it is not easy to distinguish between a secondary trend and the beginning of a new primary trend. Traders often come across misleading reversals that turn out to be just secondary trends.

 

Final considerations

Some critics argue that Dow Theory is outdated, especially when it comes to the principle of correlation between indices (which states that one index or average should support another). Still, most investors still consider Dow Theory relevant. Not only because it allows for the identification of financial opportunities, but also because of the concept of market trends, which comes into being thanks to Dow's work.