Content of this article

  • What is the Dow Theory?

  • The basic principles of the Dow Theory

    • The market reflects absolutely everything

    • Market trends

    • The three phases of a primary trend

    • Inter-index correlation

    • The importance of volume

    • Trends are valid until a reversal is confirmed

  • Conclusion


What is the Dow Theory?

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

Dow never put his ideas down on paper as a specific theory and did not refer to them as such. However, many learned from him through his op-eds in the Wall Street Journal. After his death, other editors, such as William Hamilton, refined his ideas and used his editorials to assemble what is now known as the Dow Theory.

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

 

The basic principles of the Dow Theory

The market reflects absolutely everything

This principle is closely aligned with the so-called efficient market hypothesis (EMH). Dow believed that the market presented everything at a discount, in the sense that all available information was already reflected in the price.

For example, if a company is expected to report higher positive earnings, the market will price this in before it happens. Demand for their shares will increase before the report is released, and so the price will likely not change or change shortly after this positive report is released.

In some cases, Dow observed that a company could see its stock price reduced after good announcements in the event that the announcements were not as good as expected.

This principle is still considered true by many traders and investors, especially those who use technical analysis extensively. However, those who prefer fundamental analysis disagree and argue that market value does not reflect the intrinsic value of a stock.

 

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

  • Primary trends – lasting from a few months to several years, this is the major movement of a market.

  • Secondary trends – which last from a few weeks to a few months.

  • Tertiary trends – which can fade in less than a week and rarely last more than ten days. In some cases, they may only last a few hours.

By looking at these different trends, investors can find opportunities. While the primary trend is the most important trend to consider, favorable opportunities tend to occur when secondary and tertiary trends appear to contradict the primary trend.

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

The problem now, as then, is recognizing the type of trend you are seeing, which is where deeper technical analysis comes in. Today, investors and traders use a wide range of analysis tools to help them understand what type of trend they are looking at.

 

The three phases of a primary trend

Dow has 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, asset values ​​remain low as market sentiment is mostly negative. Smart traders and market makers start accumulating during this period, before a significant price increase occurs.

  • Public Participation – The broader market is now realizing the opportunity that smart traders have already observed, and the general public is becoming more and more active in buying. During this phase, prices tend to increase rapidly.

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

In a bear market, the phases would essentially be reversed. The trend would begin with the distribution of those who perceive the warning signs, followed then by public participation in the distribution. In the third phase, the public would continue to despair, but investors being able to see the coming change begin to accumulate again.

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

 

Inter-index correlation

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

At the time, the transport market (mainly railways) was strongly linked to industrial activity. It goes without saying: to produce more goods, it was first necessary to increase railway activity in order to provide the necessary raw materials.

As such, there was a clear correlation between the manufacturing industry and the transportation market. If one was healthy, the other probably would be healthy too. However, the principle of inter-index correlation doesn't hold up quite as well these days because many goods are digital and don't require physical delivery.

 

The importance of volume

As is the case for many investors now, Dow believed in volume as a crucial secondary indicator, meaning that a strong trend should 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, price action may not represent the true market trend.

 

Dow believed that if the market showed a trend, it would continue in the direction of that trend. So, for example, if a company's stock begins to rise after positive news, it will continue to do so until a definitive reversal is shown.

Because of this, Dow believed that reversals should be treated with suspicion until they were confirmed as a new main trend. Of course, it is not easy to distinguish between a secondary trend and the start of a new primary trend, and traders often encounter misleading reversals that eventually turn out to be secondary trends.

 

To conclude

Some critics argue that the Dow Theory is outdated, especially with regard to the principle of correlation between indices (which indicates that one index or average must support another). Yet most investors consider the Dow Theory relevant today. Not only because it plays a role in identifying financial opportunities, but also because the concept of market trends that Dow created still seems valid today.