Dow Theory was formulated from a series of Wall Street Journal’s editorials authorized by Charles H. Dow from 1900 until the time of his death in 1902. These editorials reflected Dow’s belief’s on how the stock market behaved and how the market could be used to measure the health of the business environment.
Due to his death, Dow never published his complete Theory on the markets, but several followers and associated have published works that have expanded on the editorials. Some of the most important contributions to Dow Theory were William P. Hamilton’s “The Stock Market Barometer” (1922), Robert Rhea’s “The Dow Theory” (1932), E. George Schaefer’s “ How I helped more than 10,000 Investors to profit in Stocks” (1960) and Richard Russell’s “The Dow Theory Today” (1961).
The Dow Theory uses two tools:
- Daily Closing Dow Jones Transportation Average.
- Daily closing Dow Jones Industrial Average.
Dow first used his Theory to create the Dow Jones Industrial Index and the Dow Jones Rail Index (now Transportation Index), which were originally compiled by Dow for the Wall-Street Journal. Dow created these Indexes because he felt they were an accurate reflection of the business conditions within the economy, because they covered two major economic segments: industrial and rail (transportation)
The Six Basic tenets of Dow Theory are:
- The Markets Discounts Everything.
- The Three Trend Market: Dow Theory identifies three trends within the market- primary, Secondary and minor. A primary trend is the largest trend lasting for more than a year (generally one to three years), while a secondary trend is an intermediate trend that lasts three weeks to three months and is often associated with a movement against the primary trend. Finally, the minor trend often lasts less than three weeks and is associated with the movements in the intermediate trend.
- Major Trends have three phases – Accumulation Phase, Public participation phase and Distribution Phase.
- Market Indexes Must Confirm Each Other: Under Dow Theory, a major reversal from a bull to a bear market (Or vice-versa) cannot be signed unless both indexes (traditionally the Dow Industrial and Rail Averages) are in agreement. For example if one index is confirming a new primary uptrend but another Index remains in a primary downtrend, it is difficult to assume that a new trend has begun. If the two Dow Indexes are in Conflict, there is no clear trend in business conditions.
- Volume Must Confirm the Trend: Volume is also used as secondary indicator to help confirm what the price movement is suggesting.
- Trend remains in effect Until Clear Reversal Occurs.
Primary trends are made up of three phases: For an Upward trend, these phases are: the accumulation phases, the public participation phase and the excess phases. For a downward trend, the three phases are: the distribution phase, the public participation phases and the panic phase.
Dow Theory uses Trend Analysis, to determine which way the market is headed. Dow relied solely on closing prices for determining trends, not intraday price movements.