A theory which says that the market is in an upward trend if one of its averages (industrial or transportation) advances above a previous important high, it is accompanied or followed by a similar advance in the other.
The theory also says that when both averages dip below previous important lows, it’s regarded as an indicator of a downward trend.
Dow created the Industrial Average, of top blue chip stocks, and a second average of top railroad stocks (now the Transport Average). He believed that the behavior of the averages reflected the hopes and fears of the entire market. The behavior patterns that he observed is applied to markets throughout the world.
Primary Movements have Three Phases
Look out for these general conditions in the market:
Bull markets
* Bull markets commences with reviving confidence as business conditions improve.
* Prices rise as the market responds to improved earnings
* Rampant speculation dominates the market and price advances are based on hopes and expectations rather than actual results.
Bear markets
* Bear markets start with abandonment of the hopes and expectations that sustained inflated prices.
* Prices decline in response to disappointing earnings.
* Distress selling follows as speculators attempt to close out their positions and securities are sold without regard to their true value.
Ranging Markets
* A secondary reaction may take the form of a ‘line’ which may endure for several weeks.
* Price fluctuates within a narrow range of about five per cent.
The six basic tenets of Dow Theory as summarized by Hamilton, Rhea, and Schaefer are described below.
1. The market has three movements
(1) The “main movement”, primary movement or major trend may last from less than a year to several years. It can be bullish or bearish.
(2) The “medium swing”, secondary reaction or intermediate reaction may last from ten days to three months and generally retraces from 33% to 66% of the primary price change since the previous medium swing or start of the main movement.
(3) The “short swing” or minor movement varies with opinion from hours to a month or more. The three movements may be simultaneous, for instance, a daily minor movement in a bearish secondary reaction in a bullish primary movement.
2. Market Trends have three phases
Dow Theory asserts that major market trends are composed of three phases: an accumulation phase, a public participation phase, and a distribution phase.
The accumulation phase (phase 1) is a period when investors “in the know” are actively buying (selling) stock against the general opinion of the market. During this phase, the stock price does not change much because these investors are in the minority absorbing (releasing) stock that the market at large is supplying (demanding).
Eventually, the market catches on to these astute investors and a rapid price change occurs (phase 2). This occurs when trend followers and other technically oriented investors participate. This phase continues until rampant speculation occurs.
At this point, the astute investors begin to distribute their holdings to the market (phase 3).
3. The stock market discounts all news
Stock prices quickly incorporate new information as soon as it becomes available. Once news is released, stock prices will change to reflect this new information. On this point, Dow Theory agrees with one of the premises of the efficient market hypothesis.
4. Stock market averages must confirm each other
In Dow’s time, the US was a growing industrial power. The US had population centers but factories were scattered throughout the country. Factories had to ship their goods to market, usually by rail. Dow’s first stock averages were an index of industrial (manufacturing) companies and rail companies. To Dow, a bull market in industrials could not occur unless the railway average rallied as well, usually first. According to this logic, if profits of manufacturers’ are rising, it follows that they are producing more. If they produce more, then they have to ship more goods to consumers. Hence, if an investor is looking for signs of health in manufacturers, he or she should look at the performance of the companies that ships the output of them to market, the railroads. The two averages should be moving in the same direction. When the performance of the averages diverge, it is a warning that change is in the air.
Both Barron’s Magazine and the Wall Street Journal still publish the daily performance of the Dow Jones Transportation Index in chart form. The index contains major railroads, shipping companies, and air freight carriers in the US.
5. Trends are confirmed by volume
Dow believed that volume confirmed price trends. When prices move on low volume, there could be many different explanations why. An overly aggressive seller could be present for example. But when price movements are accompanied by high volume, Dow believed this represented the “true” market view. If many participants are active in a particular security, and the price moves significantly in one direction, Dow maintained that this was the direction in which the market anticipated continued movement. To him, it was a signal that a trend is developing.
6. Trends exist until definitive signals prove that they have ended
Dow believed that trends existed despite “market noise”. Markets might temporarily move in the direction opposite to the trend, but they will soon resume the prior move. The trend should be given the benefit of the doubt during these reversals. Determining whether a reversal is the start of a new trend or a temporary movement in the current trend is not easy. Dow Theorists often disagree in this determination. Technical analysis tools attempt to clarify this but they can be interpreted differently by different investors.
Conclusions
The goal of Dow and Hamilton was to identify the primary trend and catch the big moves. They understood that the market was influenced by emotion and prone to over-reaction both up and down. With this in mind, they concentrated on identification and following: identify the trend and then follow the trend. The trend is in place until proved otherwise. That is when the trend will end, when it is proved otherwise.
Dow theory helps investors identify facts, and not making assumptions or forecast. It can be dangerous when investors and traders begin to assume. Predicting the market is difficult, if not impossible, game. Hamilton readily admitted that the Dow theory was not infallible. While Dow theory may be able to form the foundation for analysis, it is meant as a starting point for investors and traders to develop analysis guidelines that they are comfortable with .
Reading the markets is an empirical science. As such there will be exceptions to the theorems put forth by Hamilton and Dow. They believed that success in the markets requires serious study and analysis that would be fraught with successes and failures. Success is a great thing, but don’t get too smug about it. Failures, while painful, should be looked upon as learning experiences. Technical analysis is a form of art and the eye grows keener with practice. Study both successes and failures with an eye to the future.