The Dow theory is the oldest and the most respected theories written in the field of financial technical analysis. The principles of the theory were proposed in the late 19th century by Charles Dow, the founder of the Dow Jones Industrial Average (DJIA) and Dow Jones Transportation Average (DJTA), in his editorials. After Dow’s death, William Hamilton refined and published Dow’s tenets in his book ‘The Stock Market Barometer’ in 1922. And following Hamilton’s death, Robert Rhea further refined and published the book ‘The Dow theory’ in 1932. Despite being proposed more than a century ago, the Dow theory has stood the test of time in spite of strong advances made in the field of financial technical analysis over the last 100 years.
The theory was originally written keeping in mind the DJIA and DJTA indices. However, the principles of the Dow theory are applicable to all other indices as well. Back then, trends in these two indices were used to gauge the overall well-being of the U.S. economy. For example, confirmation of a primary uptrend from both the indices was used as a signal that the broader market was also trending in the same direction.
Principles of Dow theory
For a better understanding of Charles Dow's writings and their implications, here are the six basic tenets that underpin the Dow theory.
One: The market discounts everything
In other words, the prices of stocks and indices reflect all available information, and the only information that cannot be reflected is that which is unknowable. This is known as the Efficient Market Hypothesis (EMH).
Two: The three-trend market
Dow theory highlights that primary trends tend to last for one year or more. They dictate whether a market is bullish (upward moving) or bearish (downward moving). Secondary trends are the corrective moves within a primary trend. They typically last between three weeks and three months, and lead to stock market corrections (a drop in stock prices) in a bull market and rallies (upticks in stock prices) in a bear market. Finally, there are minor trends that only last a matter of days and which are largely "market noise", in other words, unpredictable short-term fluctuations in stock prices.
Three: primary trends remain in effect until a clear reversal occurs
This is one of the more controversial elements of Dow theory. Indeed, reversals in primary trends can easily be confused with the emergence of secondary trends. The Dow Theory therefore advocates caution, as it is difficult to distinguish between the two until after the event.
Four: the three phases of primary trends
The first phase of primary trends determines that informed investors profit from an accumulation phase (before a bull market) or a distribution phase (before a bear market). Traders then move towards a second public participation phase, which is when the largest price movement occurs. Finally, the market experiences a third excess phase, characterised by a period of euphoria (at the end of a bull market), or of panic/despair (at the end of a bear market).
Five: volume must confirm the primary trends
Volume should increase in the direction of the trend in order to give confirmation. It is only a secondary indication but Dow realised that if volume didn't increase in the direction of the trend, this is a red flag. This means that the trend may not be valid.
Six: primary trends must confirm each other across market indices
This last tenet, that two opposing primary trends cannot coexist on two different market indices, was undoubtedly the most important to Charles Dow. In other words, the primary trend discovered on a market index must always be confirmed by a similar trend on another market index and vice versa.
It was in response to this final tenet that Charles H. Dow did not stop at creating the Dow Jones Industrial Average. He also contributed to the development of another market index, the Dow Jones Transportation Average.