Dow Theory is the composite work of Charles Dow, William Hamilton, and Robert Rhea. Dow Theory was based on analysing the general swings in the market, with the aim of identifying the general trends. A lot of this work underpins modern technical analysis studies.
There are a number of basic principles of Dow Theory. These include ‘the average discounts everything’, ‘the market has three movements’, ‘both averages must confirm for a trend to be valid’ and ‘volume provides additional evidence’.
The ‘averages discount everything’ is well explained by Rhea in his book ‘The Dow Theory’, reprinted by Fraser Publishing Company, Vermont in 1932, which states:
“The fluctuations of the daily closing prices of the Dow Jones rail and industrial averages afford a composite index of all the hopes, disappointments and knowledge of everyone who knows anything of financial matters and for that reason the effects of coming events (excluding acts of God) are always properly anticipated in their movement. The averages quickly appraise such calamities as fires and earthquakes.”
The market has three movements, which are the primary trend, the secondary reaction, and the daily fluctuation.
The primary trend is the overall movement of the market over an extended period of time from anywhere between less than a year to several years. The average of a primary movement is more than two years although there is no method of forecasting this.
The main factor in a primary bull trend is the demand created by investment and speculative buying caused by improving business conditions and increased speculative activity.
The primary bear trend is created by the supply caused by a variety of economic bad news and does not end until prices have discounted the worst of what could be expected to occur.
The second type of movement is the secondary reaction. This is a decline in a bull market and a rally in a bear market. On average, these movements will last from several weeks out to several months. It has been observed that in a bull market, prices can decline between 33% and 66% of the price change since the last secondary reaction. Similarly, prices can climb between 33% and 66% of the price change since the last secondary reaction in a bear market.
The third type of movement is the daily fluctuation which was considered unimportant by Dow, Hamilton and Rhea. Furthermore, Dow believed that the daily fluctuations had no influence in determining the overall trend and could almost be misleading. He was concerned mainly with identifying the primary and secondary movements only.
Interestingly, despite Dow’s opinion of the unimportance of the daily fluctuation, many present day traders consider daily fluctuations in their analysis and trade short term. Notwithstanding that, many could probably benefit from considering trends of a greater time period even if only trading short term.
The primary trend is the overall movement of the market over an extended period of time from anywhere between less than a year to several years. There are three phases within a primary trend.
According to Rhea, the three phases in a bull primary trend are:
- The first is represented by reviving confidence in the future of business,
- The second is the response of stock prices to the known improvement in corporate earnings, and
- The third is the period when speculation is rampant and inflation apparent – a period when stocks are advanced on hopes and expectations.
He went on to add that the three phases of a bear primary trend are:
- The first represents the abandonment of the hopes upon which stocks were purchased at inflated prices,
- The second reflects selling due to decreased business and earnings, and
- The third is caused by distress selling of sound securities, regardless of their value.
Rhea also formalised a definition of a trend and is similar to what technical analysts use today. A bullish trend is defined as ‘successive rallies penetrating preceding high points, with ensuing declines terminating above preceding low points’. A bearish trend is defined as a ‘failure of rallies to penetrate preceding high points, with ensuing declines carrying below former low points’.
Another important principle of Dow Theory is that ‘both averages must conform’. On 26th May 1896, Dow split the industrial and transportation companies that were the original Dow Jones Index into two different averages.
The profits of the transportation companies were very sensitive to the volume of goods being carried. These goods were being manufactured by the Industrial companies and immediately, there was a connection between the two types of companies.
Both the amount of goods being carried and the goods being manufactured were reported regularly. It became clear that at the start of a bullish period, the amount of goods being ordered increased and then stock held decreased quickly, before the level of manufacturing could increase to maintain stock levels.
Conversely, at the start of a bearish period, the amount of goods being ordered decreased and stock held increased, before the level of manufacturing could decrease to reflect the falling demand. Rhea commented that ‘the movements of one average, unconfirmed by the other, are certain to prove misleading.’