Dow Theory

What Is the Dow Theory?

The Dow theory is a financial theory that says the market is in an upward trend if one of its averages (i.e. industrials or transportation) advances above a previous important high and is accompanied or followed by a similar advance in the other average. For example, if the Dow Jones Industrial Average (DJIA) climbs to an intermediate high, the Dow Jones Transportation Average (DJTA) is expected to follow suit within a reasonable period of time.

Understanding the Dow Theory

The Dow theory is an approach to trading developed by Charles H. Dow who, with Edward Jones and Charles Bergstresser, founded Dow Jones & Company, Inc. and developed the Dow Jones Industrial Average in 1896. Dow fleshed out the theory in a series of editorials in the Wall Street Journal, which he co-founded.

Dow believed that the stock market as a whole was a reliable measure of overall business conditions within the economy and that by analyzing the overall market, one could accurately gauge those conditions and identify the direction of major market trends and the likely direction of individual stocks.

The theory has undergone further developments in its 100-plus-year history, including contributions by William Hamilton in the 1920s, Robert Rhea in the 1930s, and E. George Shaefer and Richard Russell in the 1960s. Aspects of the theory have lost ground, for example, its emphasis on the transportation sector — or railroads, in its original form — but Dow's approach still forms the core of modern technical analysis.

How the Dow Theory Works

There are six main components to the Dow theory.

1. The Market Discounts Everything

The Dow theory operates on the efficient markets hypothesis (EMH), which states that asset prices incorporate all available information. In other words, this approach is the antithesis of behavioral economics.

Earnings potential, competitive advantage, management competence — all of these factors and more are priced into the market, even if not every individual knows all or any of these details. In more strict readings of this theory, even future events are discounted in the form of risk.

2. There Are Three Primary Kinds of Market Trends

Markets experience primary trends which last a year or more, such as a bull or bear market. Within these broader trends, they experience secondary trends, often working against the primary trend, such as a pullback within a bull market or a rally within a bear market; these secondary trends last from three weeks to three months. Finally, there are minor trends lasting less than three weeks, which are largely noise.

3. Primary Trends Have Three Phases

A primary trend will pass through three phases, according to the Dow theory. In a bull market, these are the accumulation phase, the public participation (or big move) phase, and the excess phase. In a bear market, they are called the distribution phase, the public participation phase, and the panic (or despair) phase.

4. Indices Must Confirm Each Other

In order for a trend to be established, Dow postulated indices or market averages must confirm each other. This means that the signals that occur on one index must match or correspond with the signals on the other. If one index, such as the Dow Jones Industrial Average, is confirming a new primary uptrend, but another index remains in a primary downward trend, traders should not assume that a new trend has begun.

Dow used the two indices that he and his partners invented, the Dow Jones Industrial Average (DJIA) and the Dow Jones Transportation Average (DJTA), on the assumption that if business conditions were, in fact, healthy, as a rise in the DJIA might suggest, the railroads would be profiting from moving the freight this business activity required. If asset prices were rising but the railroads were suffering, the trend would likely not be sustainable. The converse also applies: if railroads are profiting but the market is in a downturn, there is no clear trend.

5. Volume Must Confirm the Trend

Volume should increase if the price is moving in the direction of the primary trend and decrease if it is moving against it. Low volume signals a weakness in the trend. For example, in a bull market, the volume should increase as the price is rising, and fall during secondary pullbacks. If in this example the volume picks up during a pullback, it could be a sign that the trend is reversing as more market participants turn bearish.

6. Trends Persist Until a Clear Reversal Occurs

Reversals in primary trends can be confused with secondary trends. It is difficult to determine whether an upswing in a bear market is a reversal or a short-lived rally to be followed by still lower lows, and the Dow theory advocates caution, insisting that a possible reversal be confirmed.

Special Considerations

Here are some additional points to consider about Dow Theory.

Closing Prices and Line Ranges

Charles Dow relied solely on closing prices and was not concerned about the intraday movements of the index. For a trend signal to be formed, the closing price has to signal the trend, not an intraday price movement. 

Another feature in Dow theory is the idea of line ranges, also referred to as trading ranges in other areas of technical analysis. These periods of sideways (or horizontal) price movements are seen as a period of consolidation, and traders should wait for the price movement to break the trend line before coming to a conclusion on which way the market is headed. For example, if the price were to move above the line, it's likely that the market will trend up.

Signals and Identification of Trends

One difficult aspect of implementing Dow theory is the accurate identification of trend reversals. Remember, a follower of Dow theory trades with the overall direction of the market, so it is vital that they identify the points at which this direction shifts.

One of the main techniques used to identify trend reversals in Dow theory is peak-and-trough analysis. A peak is defined as the highest price of a market movement, while a trough is seen as the lowest price of a market movement. Note that Dow theory assumes that the market doesn't move in a straight line but from highs (peaks) to lows (troughs), with the overall moves of the market trending in a direction.

An upward trend in Dow theory is a series of successively higher peaks and higher troughs. A downward trend is a series of successively lower peaks and lower troughs.

The sixth tenet of Dow theory contends that a trend remains in effect until there is a clear sign that the trend has reversed. Much like Newton's first law of motion, an object in motion tends to move in a single direction until a force disrupts that movement. Similarly, the market will continue to move in a primary direction until a force, such as a change in business conditions, is strong enough to change the direction of this primary move.

Reversals

A reversal in the primary trend is signaled when the market is unable to create another successive peak and trough in the direction of the primary trend. For an uptrend, a reversal would be signaled by an inability to reach a new high followed by the inability to reach a higher low. In this situation, the market has gone from a period of successively higher highs and lows to successively lower highs and lows, which are the components of a downward primary trend.

The reversal of a downward primary trend occurs when the market no longer falls to lower lows and highs. This happens when the market establishes a peak that is higher than the previous peak, followed by a trough that is higher than the previous trough, which are the components of an upward trend.