A brief history of Dow Theory
In 1882, Charles Henry Dow co-founded Dow Jones Company (a publishing company of financial news) with his partners Edward Jones and Charles Bergstresser.
Charles Dow was also the editor of The Wall Street Journal which was founded to cover business and financial news, its first issue was published in 1889. He wrote a series of editorials in The Wall Street Journal.
Charles Dow developed certain stock averages to understand market movement in a better way and one of the most famous was Dow Jones Industrial Average which was developed in 1896. Dow Jones Industrial Average included 12 companies from the industrial sector; he calculated their average by adding their stock prices and dividing them by 12.
To compensate the changes occur due to certain factors like stock splits, mergers, stock substitution, and dividend changes with time, Dow Divisor was introduced to maintain the consistency of average and it is being adjusted with time so that events like stock splits, mergers, stock substitution, and dividend changes do not alter the true value of Dow Jones Industrial Average.
According to Charles Dow, the Stock market can be used to measure the overall business environment in a particular economy and market averages can be used to identify the major market trend. So he took his two relatable averages one was Dow Jones Industrial Average and the other one was Dow Jones Rail Average (which is now known as Dow Jones Transportation Average).
The idea behind this was when one of the two averages moves above the previous high, the other one should follow it to confirm the uptrend and if this doesn’t happen and averages diverge, it should be considered as a warning signal.
Similarly, when one of the two averages moves below the previous low, the other one should follow it to confirm the downtrend and if this doesn’t happen and averages diverge, it should be considered as a warning signal.
What is Dow Theory?
Dow Theory is an approach to identify the direction or trend of the market based on the analysis of the relationship between market averages.
Unfortunately, Charles Dow died in 1902 and never wrote a book and his ideas on the market behaviour were only set down in the editorials of The Wall Street Journal.
After his death, S.A Nelson compiled his writings in a book entitled “ABC of stock speculation” where he first coined the term “Dow Theory”. William Peter Hamilton, Dow’s associate and successor at the journal categorized and published Dow’s Principles in a book named “Stock market barometer”. In 1932, Robert Rhea developed the theory even further and collectively published the writings in his book “The Dow Theory”.
Principles of Dow Theory
1. Market discounts everything
According to this principle, the market price of an asset reflects all the information associated with it or every possible factor that could affect its demand and supply.
2. The market has three trends
- Primary trend – It is a major trend of the market which lasts for a year or more, reflecting typically a bull or a bear market.
- Secondary trend – It is an intermediate trend and is actually a correction in the primary trend as it moves in the opposite direction to the primary trend like retreating in a bull market and advancement in a bear market. It lasts for 3 weeks to 3 months.
- Minor trend – It is a correction in Secondary trend as it moves against it. It is considered a “noisy market”. It lasts for less than 3 weeks.
3. Primary Trend or Major Trend has 3 phases
According to Dow Theory, Primary Trend or Major Trend has 3 Phases;
- Phase 1 – Accumulation Phase
- Phase 2 – Public Participation Phase
- Phase 3 – Distribution Phase
4. Market indices must confirm each other
For a market trend to be confirmed, all the indices or market averages must confirm or support each other, for example, if one average is moving upwards, the other one should also follow it to confirm the uptrend.
5. Volume must confirm the trend
Market’s trend should be confirmed by high trading volumes for example in an uptrend, the volume should rise with a higher price and in a downtrend, it should rise with lower price to confirm the direction. Low volume signals a weak trend.
6. Trend continues until a strong and clear reversal occurs
Reversals in primary trends are often easily confused with secondary trends. It is difficult to determine the real reversal signal in a bull or bear market and Dow Theory recommends high alertness on strong reversal signal which confirms the reversal of a trend.