The Dow Theory is a technical analysis framework based on the work of Charles Dow. It outlines the different stages of market trends and has principles such as market trends, volume correlation, and more. While some claim that the Dow Theory is outdated, it's still viewed as relevant for identifying financial opportunities and understanding the market.
The Dow Theory Basics
Charles Dow, who founded and edited the Wall Street Journal and co-founded Dow Jones & Company, developed the Dow Theory as a technical analysis framework. Dow played a key role in creating the first stock index, namely the Dow Jones Transportation Index (DJT) and later the Dow Jones Industrial Average (DJIA). Although Dow did not write his ideas as a specific theory or refer to them as such, many learned from his editorials in the Wall Street Journal. After his death, other editors, such as William Hamilton, refined these ideas and assembled what is now known as the Dow Theory.
The Dow Theory outlines the different stages of market trends according to Dow's work. It should be noted, however, that the following principles are open to interpretation and not infallible, as with any theory.
What Are the Principles of the Dow Theory?
The Dow Theory is a fundamental framework for technical analysis of the financial markets. While some critics argue that the Dow Theory is outdated, many investors still consider it relevant today. The theory consists of several principles:
The Market Reflects Everything
The principle that all available information is already reflected in the price of a security is closely related to the Efficient Market Hypothesis (EMH) and is an essential component of the Dow Theory. Charles Dow believed that the market discounts everything, which means that the price of a security reflects all the available information.
For instance, if a company is expected to report improved earnings, the demand for its shares will increase before the report is released. Consequently, the price may not change significantly once the expected positive report is published. According to Dow, a company's stock price might even decrease after good news if the news is not as good as expected.
Although this principle is still widely believed by many traders and investors, especially those who use technical analysis extensively, it is not universally accepted. Those who prefer fundamental analysis disagree and believe that a stock's intrinsic value is not accurately reflected in its market value.
The concept of market trends is considered an essential element of the financial world, and some attribute its origin to the work of Charles Dow. The Dow Theory outlines three main types of market trends:
- Primary trend - This is the major market movement, lasting from months to many years.
- Secondary trend - This trend lasts from weeks to a few months.
- Tertiary trend - This trend typically lasts for less than a week, or not longer than ten days. In some cases, it may only last for a few hours or a day.
To find opportunities, investors analyze different trends. While the primary trend is important, favorable opportunities can arise when secondary and tertiary trends seem to contradict it. For example, if a cryptocurrency has a positive primary trend but experiences a negative secondary trend, there may be an opportunity to buy it at a lower price and sell it when its value increases. Technical analysis is key to recognizing which type of trend is being observed. Today, investors use a wide range of analytical tools to understand trends.
The Three Phases of Primary Trends
Dow established that long-term primary trends have three phases, with each phase being essential to the movement of the market. In a bull market, the three phases are accumulation, public participation, and excess and distribution.
- During the accumulation phase, smart traders start buying while the market sentiment is still low.
- Public participation is the second phase when the market sees rapid price increases.
- In the third phase, excess and distribution occur, and the market is nearing its end.
In contrast, in a bear market, these phases would be reversed. Investors who can see the upcoming shift will begin accumulating again. Although there is no guarantee that these phases hold true, many investors consider them before taking action. The Wyckoff Method relies on similar concepts of market cycles, with accumulation and distribution being essential to understanding the market's movement.
Cross-Correlation of Indexes
According to Dow, the trends observed on one market index should be confirmed by those seen on another. This was primarily related to the Dow Jones Transportation Index and Dow Jones Industrial Average.
Back then, transportation (mostly railroads) was closely tied to industrial activity because an increase in rail activity was needed to provide the necessary raw materials for goods production. Therefore, a correlation existed between the manufacturing industry and the transportation market, and if one was healthy, the other was likely to be so as well.
However, this principle of cross-index correlation is not as applicable today because many goods are digital and do not require physical delivery.
Volume Plays a Massive Role
According to Dow, a strong trend should be accompanied by high trading volume. In other words, if the trading volume is high, it is more likely that the trend reflects the actual market direction. Conversely, if the trading volume is low, the price movement may not accurately represent the true market trend.
The Trend Is Valid Until the Confirmation of the Reversal
Dow's theory posits that a market that is trending will continue to do so until a clear reversal is shown. For instance, if a company's stock starts to rise following the positive news, it will continue to do so until a definitive reversal occurs. As a result, Dow advocated treating reversals with caution until they are confirmed as a new primary trend. Nonetheless, distinguishing between a secondary trend and the start of a new primary trend is challenging, and traders often encounter deceptive reversals that turn out to be just secondary trends.
While some critics claim that the Dow Theory is no longer applicable, especially regarding cross-index correlation, many investors still view it as relevant. Dow's work has created the concept of market trends, making it important not only for identifying financial opportunities but also for analyzing and understanding the market.