What Is the Dow Theory in technical analysis?
Dow theory primarily has six tenets which is derived from 255 editorials of Charles H Dow who is the founder editor of Wall Street Journal. Charles H Dow made several observations on stock market movements which is the foundation of modern-day technical analysis of stock market and other financial markets. Hence, six doctrines or tenets of Dow theory is nothing but Dow theory in technical analysis.
Various tools on charting software in modern day are used to understand market movements and accordingly place trading positions based on prevailing stock market trends. Ultimately charting tools or charting software provide all necessary drawing tools to understand stock market or financial markets based on Dow theory in technical analysis and sometimes referred as Dow theory in stock market
In nutshell, Dow talked about importance of price movements that form the market structure on price chart and role of volume to confirm the trend. Dow also emphasized that all news etc. are discounted in price and stock market works on efficient market hypothesis.
Dow also indicated that different market indices must confirm to each other based on price action and volume and trend remains intact unless price action gives definite signal indicating reversal.
Historical facts on Dow theory
The Dow theory is an analytical approach towards trading in financial markets explained by Charles H Dow through editorials in Wall Street Journal who also founded Dow Jones & Company and designed the Dow Jones Industrial Average way back in 1896.
Due to the death of Charles H Dow in 1902, the observations made by him could not be published as theory. However, his commendable observations were later published by his fans and associates based on Dow’s 255 editorials in WSJ.
Noted contributions by contributors on Dow theory are as below:
- William P. Hamilton | The Stock Market Barometer in 1922
- Robert Rhea | The Dow Theory in 1932
- George Schaefer | How I helped more than 10,000 investors to profit in stocks in 1960.
- Richard Russell | The Dow Theory Today in 1961
Charles H Dow was of the opinion based on his elaborate observations on stock market data that the stock market is an indicator of the business environment, business health, business conditions, etc in the overall economy and thus we can say that the stock market is a leading indicator of economic conditions which helps to know the primary or major trends of the stock market and individual shares of companies.
Six basic doctrines of Dow theory | basis of technical analysis
- The stock market has three price movements.
- The main movement also referred to as the primary movement or major trend which typically lasts from less than a year to many years. It can be a bullish or bearish trend.
- The secondary reaction or intermediate reaction may last from two weeks to three months and generally corrects from 33% to 66% of the primary or major price move. We understand it as a reaction to a prior impulsive wave forming a corrective wave. As a result, we as technical analysts focus more on Fibonacci retracement levels of 38.2% and 61.8% whenever corrective waves are formed.
- The minor movement lasts from hours to a month or even a little more.
- the stock market has three market phases.
Dow theory emphasizes that main market trends have three phases as mentioned below:
- an accumulation phase when smart money flows into the stock market post-down-trending moves
- a public participation phase which is also called mark up phase or reaccumulating phase.
- a distribution phase whereby it indicates a withdrawal of smart money.
- the stock market then enters the markdown phase which is also referred to as the redistribution phase, and this may be considered as the fourth phase.
- The stock market discounts all news.
Stock prices tend to quickly incorporate any related news or any kind of new information the moment it becomes available. Dow theory indicated that the stock market operates efficiently and hence price discounts all news and information. So, the stock market works on the efficient market hypothesis
- Stock market averages must fall in line with each other.
When Charles H Dow wrote editorials in WSJ, the USA was on growth as industrial power and manufacturing units were quite scattered. These manufacturing units were required to ship the finished goods to various end-users through Railways. As a result, Dow designed an index of industrial or manufacturing companies and rail companies so that it can be seen during the bull market where stock prices of manufacturing companies are rising, shares of rail companies must also rise and there should not be any discrepancies in these averages or indices.
With the stipulation in the preceding para, logic is quite simple to understand, if manufacturers’ profits are growing, which implies that they are manufacturing more goods. If they produce more, then they are required to ship more goods to end-users. If these two indices are not confirming to each other, it gives an alarm that the rise in price may not sustain.
Wall Street Journal (WSJ) still publish the daily performance of the Dow Jones Transportation Average index. This index incorporates major railroads, shipping companies, and air freight carriers in the USA.
- Volume confirms the stock market trends.
According to Dow, volume confirms the trend as it indicates the extent of participation in the stock market or in an individual stock. when price movements are accompanied by high volume, Dow believed this represented the “true” market view.
- Stock market trends remain intact unless it gives a definite signal for reversal.
Dow believed that trends existed despite “market noise”. Markets might temporarily move in the direction opposite to the trend, but they will soon resume the prior move. Hence pullbacks are normal market behavior in a trending market as the market resumes its original trend after the correction is over.