Dow Theory is a type of technical analysis that incorporates certain features of sector rotation.
Charles H. Dow (1851–1902), journalist, founder and first editor of the Wall Street Journal, and co-founder of Dow Jones and Company, wrote 255 Wall Street Journal editorials that formed the basis of the idea.
Following Dow’s death, William Peter Hamilton, Robert Rhea, and E. George Schaefer formed and represented “Dow Theory,” which was based on Dow’s editorials. Dow never used the name “Dow Theory,” nor did he promote it as a trading strategy.
The six fundamental principles of Dow Theory are outlined here.
Six Basic Principles of Dow Theory
- There are three movements in the market.
(1) The “principal movement,” “primary movement,” or “major trend” might extend from a few months to several years.
It may be both bullish and bearish.
(2) The “medium swing,” secondary response, or intermediate reaction can last anywhere from ten days to three months and typically retraces between 33% and 66% of the major price shift since the preceding medium swing or the commencement of the main movement.
(3) The duration of the “brief swing” or small movement varies according to viewpoint, ranging from hours to a month or more. The three movements might occur at the same time, for example, a daily minor movement in a bearish secondary response in a bullish primary movement.
- Market trends are divided into three phases.
According to Dow Theory, important market trends are divided into three stages: accumulation, public involvement, and distribution.
The accumulation phase (phase 1) is a time when “in the know” investors aggressively acquire (sell) shares against market sentiment.
The stock price does not move significantly during this period since these investors are in the minority, absorbing (releasing) shares that the market as a whole is supplying (demanding).
The market eventually catches on to these savvy investors, and a dramatic price movement happens (phase 2).
When trend followers and other technically minded investors participate, this happens.
This stage will last until there is widespread conjecture. At this time, savvy investors begin to sell their assets to the market (phase 3).
- All news is discounted in the stock market.
As soon as new information becomes available, stock prices immediately integrate it.
When new information is revealed, stock prices will adjust to reflect this new knowledge. Dow Theory accords with one of the axioms of the efficient market hypothesis on this issue.
- Stock market averages must coincide with each other.
The United States was a developing industrial power during Dow’s period. The United States had population centers, but manufacturing were dispersed across the country.
Factories were required to convey their goods to market, typically via rail.
Dow’s initial stock indices were an index of industrial (manufacturing) and rail firms.
A bull market in industrials, according to Dow, could not occur until the railway average gained as well, typically first. According to this argument, if manufacturers’ earnings are increasing, they must be creating more.
If they manufacture more, they must convey more items to customers.
As a result, if an investor is searching for indicators of health in manufacturers, he or she should consider the performance of the firms that transport their output to market, namely railways.
Both averages should be trending in the same direction. When the averages’ performance diverges, it is a sign that change is in the air.
The Dow Jones Transportation Index’s daily performance is still charted in Barron’s Magazine and the Wall Street Journal.
The index includes the largest railways, shipping firms, and air freight providers in the United States.
- Volume validates trends.
Dow felt that pricing patterns were verified by volume. There might be a variety of reasons why prices fluctuate in low volume.
For example, an extremely pushy salesperson may be present. Dow, on the other hand, thought that when price fluctuations were accompanied by large volume, this indicated the “real” market view.
If a security has a large number of participants and the price moves considerably in one way, Dow maintained that this was the direction in which the market expected continuing movement.
It was an indication to him that a pattern was emerging.
- Trends continue until definitive signs indicate that they have stopped.
Despite “market noise,” Dow thought that patterns existed.
Markets may momentarily move in the opposite direction of the trend, but they will quickly return to their previous position.
During these reversals, the trend should be given the benefit of the doubt. It is difficult to tell if a reversal marks the beginning of a new trend or merely a momentary shift in the existing trend.
Dow theorists frequently differ on this point.
Technical analysis tools attempt to clarify this, but various investors perceive them differently.
There is minimal scholarly backing for the Dow Theory’s profitability.
Alfred Cowles demonstrated in a 1934 research published in Econometrica that trading based on editorial advice would have resulted in less profit than a buy-and-hold strategy employing a well-diversified portfolio.
Cowles found that a buy-and-hold strategy provided 15.5 percent annualised returns from 1902 to 1929, but the Dow Theory approach delivered 12 percent yearly returns.
Many academics stopped researching Dow Theory after several studies corroborated Cowles’ findings over the next few years, believing Cowles’ findings were solid.