Dow Theory Explanation
1. Theoretical Basis
General Principle: Dow Theory states that the stock market reflects all available information, including economic, political news, and investor psychology. The market tends to move in trends, which can be analyzed to predict future movements.
2. Three Main Trends
Primary Trend: A long-term trend lasting from several months to several years. It can be bullish (bull market) or bearish (bear market).
Secondary Trend: A medium-term trend lasting from a few weeks to a few months. It may go against the primary trend but is typically part of a correction process.
Minor Trend: A short-term trend lasting from a few days to a few weeks. These are small price fluctuations.
3. Confirmation Principle
A trend is only considered valid when confirmed by both market indices: the industrial index and the railroad index (historically) or other indices like the S&P 500 today. If both indices move in the same direction, the trend is validated.
4. Market Phases
Accumulation Phase: The market shows little volatility, and investors buy when prices are low.
Advancing Phase: Investors begin to participate, causing prices to rise sharply.
Distribution Phase: When prices peak, investors start to sell, leading to a downtrend.
5. Market Psychology
Investor psychology greatly influences market trends. Dow Theory emphasizes that psychological factors like skepticism and greed can strongly affect market behavior.
6. Practical Significance
Dow Theory helps investors determine when to enter or exit the market, allowing for more informed investment decisions.
7. Limitations
Although Dow Theory has many applications, it also has drawbacks. Some investors believe it is not always accurate and can lead to poor decisions if not combined with other analytical methods.
Summary Dow Theory provides a basic framework for understanding stock market fluctuations through trends. It emphasizes the importance of monitoring trends and market psychology to make smart investment decisions.
