- 1 History
- 2 Core statements
- 2.1 The indices discounted everything
- 2.2 The market is following three trends
- 2.3 Primary trends have three phases
- 2.4 Indices must confirm each other
- 2.5 The volume must confirm the trend
- 2.6 A trend exists until there are definite signals that it has reversed
- 3 Conclusions
- 4 Literature
The Dow theory has been around for nearly 100 years, but even in today’s volatile and technology-driven markets, the basic components of the Dow theory remain valid. The Dow theory, developed by Charles Dow, refined by William Hamilton and articulated by Robert Rhea, covers not only technical analyses and price actions, but also market philosophy. Many of the ideas and comments of Dow and Hamilton became axioms of Wall Street. While there are those who can think that the market is different now, reading Rhea’s book, The Dow Theory, will confirm that the stock market behaves exactly as it did almost 100 years ago.
The Dow Theory describes market trends and their typical behavior. On a more detailed level, it provides signals that can be used to identify the primary market trend and/or indicate a change in that trend. The theory focuses on identifying the trend for the Dow Jones Rail (now Transportation) Average and the Dow Jones Industrial Average and confirming it with volume. If both Dow Jones averages tend in the same direction, then it can be said that the entire market also tends in this direction. Investors can use these signals to identify the primary market trend and then trade that trend.
Charles Dow developed the Dow theory from his analysis of the market price action in the late 19th century. Until his death in 1902, Dow was co-owner and editor of The Wall Street Journal. Although he never wrote a book on these theories, he has written several editorials that reflect his views on speculation and the role of the rail and industrial averages.
Although Charles Dow is credited with the development of Dow theory, it was S.A. Nelson and William Hamilton who later refined the theory into what it is today. Nelson wrote The ABC of Stock Speculation and was the first to use the term “Dow Theory”. Hamilton further refined the theory through a series of articles in The Wall Street Journal from 1902 to 1929. Hamilton also wrote the 1922 Börsenbarometer, which attempted to explain the theory in detail.
In 1932 Robert Rhea further refined the analysis of Dow and Hamilton in his book The Dow Theory. Rhea read, studied and deciphered some 252 editorials through which Dow (1900-1902) and Hamilton (1902-1929) conveyed their thoughts on the market. Rhea also referred to Hamilton’s The Stock Market Barometer.
Our presentation of Dow theory in this article is based on Rhea’s book The Dow Theory, which organized the writings of Dow and Hamilton into a series of assumptions and theorems. If possible, we have also tried to combine some of the realities of today’s market with Dow theory as explained by Dow, Hamilton and Rhea.
The indices discounted everything
The notion that markets reflect all possible known factors that affect total supply and total demand is based on the basic assumptions of technical theory. The theory applies to market averages as well as to individual markets and even takes “force majeure” into account. While markets cannot predict events such as earthquakes and various other natural disasters, they quickly ignore such events and integrate their effects almost immediately into the price action.
The market is following three trends
For Dow, a market consisted of three trends. He defined an uptrend as a situation where each consecutive rally ends higher than the previous rally high, and each consecutive rally low also closes higher than the previous rally low. In other words, an uptrend has a pattern of rising peaks and valleys. The opposite situation with successive lower peaks and valleys defines a downward trend. The definition of Dow has survived the test of time and remains the cornerstone of trend analysis.
Dow considered the trend as three parts: Primary, Secondary and Minor. For Dow, the primary trend represented the ebb and flow, the secondary and medium trends the waves that make up the flow. The minor trends behave like the ripples on the waves.
Primary trends have three phases
The theory says that there are three phases to each primary trend: The accumulation phase, the public participation phase and the distribution phase.
The beginning of a primary uptrend (or downtrend) in a bull (or bear) market is called the accumulation phase. This is where traders enter the market to buy (or sell) stocks against Common Market opinions.
In the phase of public participation, more investors (trend followers) enter the market when the framework conditions improve and positive sentiments become discernible. This leads to higher (or lower) prices on the market.
The phase is characterized by excessive purchases by investors. This could lead to speculation. In this phase, it is ideal for investors to book profits and exit. In this phase, the traders who have entered the accumulation phase get out.
Indices must confirm each other
Dow felt that two averages should confirm each other, meaning that the two indices it proposed, Dow Jones Industry and Dow Jones Transport, should go hand in hand. So if the Dow Jones Industry rises higher and the Dow Jones Transport Index does not keep up, it means that something is rotten in the markets and the bullish run cannot be confirmed at this point or vice versa. Therefore, the averages have to confirm each other. If the Dow Jones Industry Index rises, the Dow Jones Transport Index must also follow.
The volume must confirm the trend
Although volume is of secondary importance, it is an important factor in confirming price signals. Volume should grow in the direction of the big trend. Volume should increase if prices move upwards in an upward trend. Accordingly, volume should increase if prices fall in a downward trend.
A trend exists until there are definite signals that it has reversed
It refers to the physical law of market movement, which states that a moving object tends to remain in motion until an external force causes it to change direction. There are now many trend reversal signals, such as support/resistances, price patterns, trend lines, moving averages. Some indicators may also indicate a loss of momentum.
The goal of Dow and Hamilton was to identify the primary trend and capture the major movements. They understood that the market was affected by emotions and susceptible to both up and down overreactions. In this sense, they focused on identification and following: Identify the trend and then follow the trend. The trend is there until the opposite is proven. Then the trend will end if it is proven otherwise.
Dow theory helps investors to identify facts and not to make assumptions or forecasts. It can be dangerous for investors and traders to start accepting. Predicting the market is a difficult, if not impossible, game. Hamilton readily admitted that the Dow theory was not infallible. While the Dow theory can provide the basis for analysis, it is intended as a starting point for investors and traders to develop analytical guidelines that they are familiar with and understand.
Reading markets is an empirical science. As such, there will be exceptions to the theorems established by Hamilton and Dow. They believed that success in the markets would require serious study and analysis, which would be associated with successes and failures. Success is a great thing, but don’t get too complacent. Failures, though painful, should be considered as learning experiences. Technical analysis is an art form and the eye becomes sharper with practice. Study both successes and failures with a view to the future.
The Dow Theory by Robert Rhea”: Published by Barron’s, this is an explanation of the development of Dow theory and an attempt to define its usefulness as a tool for speculation. Rhea carefully studied 252 editorials by Charles H. Dow and William Peter Hamilton to present Dow theory in terms that might be useful to the individual investor.