What is the Dow Theory?
Dow never wrote his ideas as a specific theory and didn’t refer to them as such. Still, many learned from him through his editorials in the Wall Street Journal. After his death, other editors, such as William Hamilton, refined these ideas and used his editorials to put together what is now known as the Dow Theory.
This article provides an introduction to the Dow Theory, discussing the different stages of market trends based on Dow’s work. As with any theory, the following principles are not infallible and are open to interpretation.
The basic principles of the Dow Theory
The market reflects everything
This principle is closely aligned with the so-called Efficient Market Hypothesis (EMH). Dow believed that the market discounts everything, which means that all available information is already reflected in the price.
For example, if a company is widely expected to report positive improved earnings, the market will reflect this before it happens. Demand for their shares will increase prior to the report being released, and then the price may not change that much after the expected positive report finally comes out.
In some cases, Dow observed that a company might see their stock price reduce after good news because it wasn’t quite as good as expected.
Some people say that Dow’s work is what gave birth to the concept of a market trend, which is now deemed as an essential element of the financial world. The Dow Theory says that there are three main types of market trends:
- Primary trend – Lasting from months to many years, this is the major market movement.
- Secondary trend – Lasting from weeks to a few months.
- Tertiary trend – Tends to die in less than a week or not longer than ten days. In some cases, they may last only for a few hours or a day.
By examining these different trends, investors can find opportunities. While the primary trend is the key one to consider, favorable opportunities tend to occur when secondary and tertiary trends seem to contradict the primary one.
The three phases of primary trends
- Accumulation – After the preceding bear market, the valuation of assets is still low as the market sentiment is predominantly negative. Smart traders and market makers start to accumulate during this period, before a significant increase in price occurs.
- Public Participation – The wider market now realizes the opportunity that smart traders have already observed, and the public becomes increasingly active in buying. During this phase, prices tend to increase rapidly.
- Excess & Distribution – In the third phase, the general public continues to speculate, but the trend is nearing its end. The market makers start to distribute their holdings, i.e., by selling to other participants who are yet to realize that the trend is about to reverse.
In a bear market, the phases would essentially be reversed. The trend would start with distribution from those who recognize the signs and be followed by public participation. In the third phase, the public would continue to despair, but investors who can see the upcoming shift will begin accumulating again.
Back then, the transportation market (mainly railroads) was heavily linked to industrial activity. This stands to reason: for more goods to be produced, an increase in rail activity was first needed to provide the necessary raw materials.
As such, there was a clear correlation between the manufacturing industry and the transportation market. If one were healthy, the other would likely be as well. However, the principle of cross-index correlation doesn’t hold up quite as well today because many goods are digital and don’t require physical delivery.
As many investors do now, Dow believed in volume as a crucial secondary indicator, meaning that a strong trend should be accompanied by a high trading volume. The higher the volume, the more likely it is that the movement reflects the true trend of the market. When the trading volume is low, the price action may not represent the true market trend.
Trends are valid until a reversal is confirmed
Dow believed that if the market is trending, it will continue to trend. So, for example, if a business’s stock starts to trend upwards after positive news, it will continue to do so until a definite reversal is shown.
Because of this, Dow believed that reversals should be treated with suspicion until they are confirmed as a new primary trend. Of course, distinguishing between a secondary trend and the beginning of a new primary trend is not easy, and traders often face misleading reversals that end up being just secondary trends.
Some critics argue that the Dow Theory is outdated, especially in regard to the principle of cross-index correlation (which states that an index or average must support another). Still, most investors consider the Dow Theory to be relevant today. Not only because it concerns identifying financial opportunities, but also because the concept of market trends that Dow’s work created.