Dow theory’s six basic tenets

  • Charles Dow (left) & Edward Jones (right) established Dow Jones & Company in 1882.
charles-dow-edward-jones-both

 

  • They created the two indices i.e., the Dow Jones Industrial Average (DJIA) and the Dow Jones Transportation Average (DJTA) to provide a good indication of the health of the economy.
  • Dow explored the relationship between the two indices and published his theories in editorials in the Wall Street Journal, which pioneered Technical Analysis.
  • Even in today’s highly technologically developed market, Dow Theory holds its basic tenets.
  • On Dow’s death in 1902, William Hamilton continued his work of writing editorials until 1929.
  • Robert Rhea then collected the work of both of these men and used it as a basis to publish The Dow Theory in 1932.

Dow theories six basic tenets:

I. The average discounts everything: 
The market reflects all available information which can affect it positively or negatively. What it cannot anticipate is happening of the natural calamities, even that are discounted as soon as it happens. It is similar to that of the first pillar of the technical analysis; the prices of the stocks absorb all the news as soon as the information is released. Prices show the sum total of all the hopes, fears and expectations of all participants. Interest rate movements, earnings expectations, revenue projections, presidential elections, product initiatives and all else are already priced into the market.

II. The Market has three trends:
According to Dow theory, the market has only three trends
a. Primary trend: In Dow theory, primary trend is also considered as major trend in the market. It has a long term impact and may remain in effect for more than 1 year. It may also influence the secondary and minor trend. Dow looks at it as tides in the sea as it affects the overall impact dramatically.
b. Secondary trend: Dow call a correction in the primary trend as secondary trend. It usually last for three weeks to three months. It generally retraces 33% to 66% of the primary trend. In a bullish market secondary trend will be a downward movement and in a bearish market it will be a rally. Dow calls it as waves in the sea.
c. Minor trend: The “short swing” or minor movement varies with opinions from hours to a month or more.

The three trends may be simultaneous. For instance, a daily minor trend in a bearish secondary trend in a bullish primary trend.

dow-thoery-three-trend

III. The Market trends have three phases:
Dow theory believes that major market trends consist of only three phases:
Accumulation phase: It is a period when investors are actively buying (selling) stock against the general opinion of the market. At this phase trader keeps buying and selling the stock but the prices do not change as the demand is far less the supply in the market.
Absorption phase: In the second phase investor starts accumulating stock. All the technical indicator starts working as there is a huge participation in the market. This phase continues until rampant speculation occurs.
Distribution phase: After a huge hype in the prices because of the skewed supply of the stock the prices begins to retrace as the astute investors begin to distribute their holdings to the market. As a result of it the prices start falling along with the volume.

Dow-three-phases-edited

IV. Average must confirm each other:
In Dow’s time, the two averages were the Industrials and the Rails. The logic behind the theory is simple: Industrial companies manufactured the goods and the rails shipped them. When one average recorded a new secondary or intermediate high, the other average was required to do the same in order for the signal to be considered valid.
If the two averages acted in harmony, with both reaching new highs or lows around the same time period, then the prices of each was said to be confirming.
When one of these averages climbs to an intermediate high, then the other is expected to follow suit within a reasonable amount of time. If not, then the averages show “divergence” and the market is liable to reverse course.
In other words if one average went to a new high, while the other was left behind, then there was bearish divergence. If the opposite occurred, with one average reaching a new low while the other held above a previous bottom, then the divergence was bullish.

V. Volume must confirm the trend:
Dow recognized the volume as a secondary but important factor in confirming price signals. In other words volume should increase in the direction of the major trend. In a major uptrend volume should increase with the rally in price and should diminish during correction. Also in a major downtrend volume should expand with the fall in prices and should contract during upward ripples.

VI. A trend is assumed to be in effect until it gives a definite signal of reversal:
Dow was a firm believer that market remains in a trend. It may deviate for a while because of noise but it will return as soon as its effect is over. It is like Newton’s law of motion “an object in motion tends to continue in motion, until some external force causes it to change direction”.

There are many trend reversal signals like support/resistances, price patterns, trend lines, moving averages. Some indicators can also provide warnings of loss of momentum.

(Source: Technical analysis for the financial markets by John.j.Murphy)

 

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