Definition and Importance
Dow Theory is a financial framework which suggests that a significant trend in the stock market must be validated by concurrent movements in both the Dow Jones Industrial Average (DJIA) and the Dow Jones Transportation Average (DJTA). According to this principle, a primary market trend is confirmed when both these averages attain new highs or new lows together. Contrarily, if one average reaches a new high or low while the other does not, the market is likely to revert to its previous trading range, indicating a possible non-confirmation of the trend.
Historical Context
Created by Charles H. Dow, co-founder of Dow Jones & Company and The Wall Street Journal, the theory was developed in the late 19th century. It is based on a series of editorials Dow wrote concerning market behavior and stock price movements. Though never formally codified by Dow himself, his successors William P. Hamilton, Robert Rhea, and E. George Schaefer expanded upon his principles to form what is known today as Dow Theory.
Fundamental Components
-
Market Trends: Dow Theory emphasizes three types of market trends: primary (lasting a year or more), secondary (lasting from three weeks to three months), and minor (less than three weeks).
-
Phases of Market Trends: Each primary trend has three phases:
- Accumulation Phase: Informed investors begin to buy or sell stocks against the prevailing market opinion.
- Public Participation Phase: The broader market starts to recognize and follow the trend.
- Distribution Phase: Informed investors begin to exit their positions as the trend nears its end.
-
Volume’s Role: Volume must increase in the direction of the primary trend. For instance, during a bull market, volume should increase as prices rise and decrease during pullbacks.
-
Efficient Market Hypothesis (EMH) Connection: Dow Theory aligns closely with the EMH, suggesting that all available information is already reflected in stock prices.
Application and Examples
Example Scenarios
-
Bull Market Confirmation:
- If the DJIA reaches a new high and subsequently, the DJTA also reaches a new high, Dow Theory posits an ongoing bull market trend.
-
Bear Market Confirmation:
- If the DJIA drops to a new low and the DJTA follows suit with a new low, Dow Theory confirms a continued bear market.
-
Non-Confirmation:
- If the DJIA reaches a new high but the DJTA does not, it signals a potential upcoming market correction or a return to former trading ranges.
Comparisons and Related Terms
Dow Theory vs. Modern Technical Analysis
- Dow Theory: Primarily focuses on trends established through the movements of DJIA and DJTA.
- Modern Technical Analysis: Utilizes a broad range of indicators, charts, and tools beyond just index averages, including relative strength indexes (RSI), Fibonacci retracement levels, and moving averages.
Related Terms
- Primary Trend: Long-term movements which reflect the overall direction of the market over a substantial period.
- Secondary Trend: Intermediate market movements which serve as corrections to the primary trend.
- Market Sentiment: The overall attitude of investors towards a particular security or financial market.
FAQs
Q: Can Dow Theory be applied to markets other than the stock market? A: While Dow Theory was initially formulated for the stock market, its principles can be adapted to analyze other markets, such as commodities or currency markets, albeit with some modifications.
Q: Why is the Dow Jones Transportation Average important in confirming trends? A: The DJTA is considered a critical component because it represents the goods being shipped and thus reflects the broader economy’s activity levels. Its performance is a gauge for the production and consumption cycle.
Q: Is Dow Theory infallible? A: Like any theory, Dow Theory is not without its limitations. Market behaviors have evolved, and there may be instances where the theory does not accurately predict market movements.
References
- Charles H. Dow, “The Dow Theory,” The Wall Street Journal, Series of Editorials.
- William P. Hamilton, “The Stock Market Barometer,” 1922.
- Robert Rhea, “The Dow Theory,” 1932.
- E. George Schaefer, “How I Helped More Than 10,000 Investors,” 1960.
Summary
Dow Theory remains a foundational concept in market analysis, emphasizing the importance of confirming major trends through the synchronized movement of the DJIA and DJTA. While market structures have evolved, the theory’s core principles continue to provide valuable insights into market behavior and trend validation. Understanding and applying Dow Theory can lead to more informed and strategic investment decisions.
