Dow Theory Explained
Charles developed the Dow Theory before the turn of the 20th century. The Dow Theory was published in a series of articles in the Wall Street Journal. Ironically, Charles Dow also co-founded the Wall Street Journal.
Unfortunately, Charles Dow passed away in 1902 and could not publish the entire Dow Theory. Partners working on the Dow Theory and Mr. Dow have published work expanding on his articles. Dow thought the stock market was a reliable barometer for the economy. By looking at the overall stock market, investors can predict the direction of individual stocks.
This musing by Charles Dow described his thinking on stocks, “A person watching the tide coming in and who wishes to know the exact spot which marks the high tide, sets a stick in the sand at the points reached by the incoming waves until the stick reaches a position where the waves do not come up to it, and finally recede enough to show that the tide has turned. This method holds good in watching and determining the flood tide of the stock market.” Read on for more information on the Dow Theory.
What is the Dow Theory?
Charles Dow’s theory relies on six basic ideas.
- The stock market is efficient. The Dow Theory is based on the idea that every bit of information about a stock or the stock market is instantly reflected in stock prices. Therefore, using available data to pick stocks is unreliable.
- There are three kinds of market trends. First, the Dow Theory says that Primary trends in the stock market tend to last for a year or more. Primary trends can be bullish or bearish. Within Primary trends are Secondary trends. Secondary trends are short-term bull or bear corrections that last between three weeks and three months. Lastly, Minor trends are unpredictable up or down trends that only last a few days.
- Primary trends remain until confirmed by other stock indices. Since it is nearly impossible to determine if a Minor trend will continue into a Primary trend, a primary trend can be confirmed when multiple stock indices are in a clear upward or downward trend.
- Trading volumes must also confirm a Primary trend. For example, if trading volume picks up, it could indicate that a Secondary Trend is moving to a Primary Trend.
- There are three phases of a Primary Trend. The first phase of a Primary Trend is the accumulation (bull) or distribution (bear) phase. These occur while Primary Trends are identified. Once confirmed, the Primary Trend moves to a longer-term Participation Phase. At the end of the Primary Trend, the Excess Phase sets in before the Primary Trend reverses.
- Trends persist until a clear reversal occurs. This idea is a bit fuzzy. The Dow Theory states that you should be cautious when deciding if a Secondary trend is really a reversal of a Primary Trend.
With stocks having such a rough year, investors are probably wondering if the Dow Theory predicts a bearish Primary Trend. Before a Primary trend, there is a Minor trend of a stock indices moving up or down for a few days. So, we’ve likely moved past a Minor bear phase.
Next is a Secondary trend of three weeks to three months of up or down stock movements. Since it is now July and stocks have moved down since the beginning of the year, a Secondary trend is likely. However, there is much more needed to confirm a Primary Trend.
For instance, the Dow Theory says that multiple indices should confirm a Primary Trend in a clear upward or downward trend. The Dow Theory focused on sectors of the Dow Jones stock index. One-year and year-to-date returns of multiple sectors are down.
Finally, trading volume should confirm the arrival of a Primary phase and the Participation phase when investors should act. If a step up in trading volume can be approved along with the other requirements, then the Dow Theory may confirm a Primary bear phase.
Dow Theory Technical Analysis
Yes, the Dow Theory is a form of technical analysis. Traditionally, technical analysis looks at stock charts and the stock price’s movement over time to detect patterns. Traders using technical analysis hope to make short-term profits from stock price movements they’re trying to predict. The short-term nature of technical trading can be risky for investors. Technical trading is risky because past performance is an unreliable indicator of future stock price moves.
Though the Dow Theory is a form of technical analysis, it is quite different from traditional technical analysis. One big difference is that the Dow Theory advises investors to focus on long-term Primary Trends. The theory tells investors to ignore Secondary and Minor trends in stocks and stock markets. Those short-term trends are what technical traders seek to exploit.
Since the Dow Theory tells us to hold stocks during the bullish Participation Phase, it also has similarities to a long-term buy-and-hold strategy. Remember, Primary Phases can last several years. Over time, long-term investment strategies tend to take advantage of the general upswing in stock markets. In addition, long-term plans involve fewer trades and, therefore, have the benefit of lower trading costs compared to technical trading.
By waiting to confirm a Primary phase, technical analysts may argue that Dow Theorists missed part of the bull market by waiting. On the other hand, by subscribing to the Dow Theory, investors will also ignore Secondary phases that do not move to Primary phases. Thereby avoiding losses.
Like any other investment strategy, the Dow Theory is just that… a theory. Though it has many thoughtful tenets and may have produced handsome returns for investors over the years, there is no guarantee it will work indefinitely.
About BJ Cook
BJ Cook is a long-time stock nerd. He has held several roles in the equity research world and earned the right to use the CFA designation in 2014. When he’s not writing for Investment U, you can find him searching for new investment ideas. Outside the investment community, BJ is a die-hard Cubs fan.