What Is the Dow Theory?
Let me explain the Dow Theory directly to you: it's a framework established by Charles H. Dow that gauges the stock market's direction by analyzing specific market averages. You see an upward trend when one average, like the Dow Jones Industrial Average (DJIA), breaks a previous high and gets support from another, such as the Dow Jones Transportation Average (DJTA). By studying these, you can assess overall business conditions and predict market paths.
Key Takeaways
- The Dow Theory indicates market trends are confirmed by similar movements in averages like DJIA and DJTA.
- Markets have primary trends lasting a year or more, secondary ones from weeks to months, and minor ones from days to weeks.
- Primary trends include three phases: accumulation, public participation, and excess in bull markets; distribution, panic, and despair in bear markets.
- New trends need confirmation from both volume and indices, showing stronger conviction.
- Trends continue until a clear reversal is identified through peak-and-trough analysis.
The Origins and Evolution of Dow Theory
I want you to know that the Dow Theory comes from Charles H. Dow, who co-founded Dow Jones & Company and created the DJIA in 1896. He developed it through Wall Street Journal editorials. After his death in 1902, others built on it—William P. Hamilton with 'The Stock Market Barometer' in 1922, Robert Rhea's 'The Dow Theory' in 1932, E. George Schaefer's book in 1960, and Richard Russell's in 1961. Dow saw the stock market as a reflection of economic business conditions, helping predict trends. Some parts, like the focus on transportation, have faded, but it remains core to technical analysis.
Analyzing the Components of Dow Theory
There are six main components you need to grasp. First, the market discounts everything, based on the efficient market hypothesis—prices include all info, from earnings to future risks. Second, markets have three trend types: primary (bull or bear, lasting over a year), secondary (pullbacks or rallies, weeks to months), and minor (daily noise). Third, primary trends have phases—in bull markets: accumulation with rising volume, public participation as the longest phase, and excess where pros exit. In bear markets: distribution of bad news, public selling as the main phase, and panic with mass selling.
Fourth, indices must confirm each other—for a trend, signals in one like DJIA must match another like DJTA, assuming healthy business means profiting railroads. Fifth, volume confirms trends—it rises with the primary trend and falls against it; low volume shows weakness. Sixth, trends persist until clear reversals, so be cautious not to mistake secondary moves for primaries.
Important Aspects of Dow Theory to Consider
Consider this: Dow focused on closing prices, ignoring intraday swings. Line ranges are sideways periods of consolidation—wait for a break to judge direction. Identifying reversals is tough; use peak-and-trough analysis where upward trends show higher highs and lows, downward the opposite. Trends stay until reversed by forces like business changes. A reversal in uptrends happens with lower highs and lows; in downtrends, with higher ones. These can take months, so don't confuse corrections for reversals.
Frequently Asked Questions
You might ask, what are the three trends? Primary (long-term bull or bear), secondary (corrections), and minor (daily fluctuations). The goal? Identify the primary trend with proof. What affects the Dow? Stock prices in the index, influenced by various factors.
The Bottom Line
In summary, the Dow Theory identifies a market's primary trend through three trends with phases. It assumes prices reflect all info, so focus on movements, volume, and confirmations for reversals—no need to dig deeper into pricing reasons.
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