For more than 100 years Dow Theory has been used by professional traders as the main foundation for conducting technical analysis. This theory was popularized by Charles Hendry Dow in the 19th century.
1. The Market Discounts Everything
The Dow theory operates on the efficient markets hypothesis (EMH), which states that asset prices incorporate all available information. In other words, this approach is the antithesis of behavioral economics.
Earnings potential, competitive advantage, management competence—all of these factors and more are priced into the market, even if not every individual knows all or any of these details. In more strict readings of this theory, even future events are discounted in the form of risk.
2. There Are Three Primary Kinds of Market Trends
Markets experience primary trends which last a year or more, such as a bull or bear market. Within these broader trends, they experience secondary trends, often working against the primary trend, such as a pullback within a bull market or a rally within a bear market; these secondary trends last from three weeks to three months. Finally, there are minor trends lasting less than three weeks, which are largely noise.
3. Primary Trends Have Three Phases
A primary trend will pass through three phases, according to the Dow theory. In a bull market, these are the accumulation phase, the public participation (or big move) phase, and the excess phase. In a bear market, they are called the distribution phase, the public participation phase, and the panic (or despair) phase.
4. Indices Must Confirm Each Other
In order for a trend to be established, Dow postulated indices or market averages must confirm each other. This means that the signals that occur on one index must match or correspond with the signals on the other. If one index, such as the Dow Jones Industrial Average, is confirming a new primary uptrend, but another index remains in a primary downward trend, traders should not assume that a new trend has begun.
Dow used the two indices he and his partners invented, the Dow Jones Industrial Average (DJIA) and the Dow Jones Transportation Average (DJTA), on the assumption that if business conditions were, in fact, healthy, as a rise in the DJIA might suggest, the railroads would be profiting from moving the freight this business activity required. If asset prices were rising but the railroads were suffering, the trend would likely not be sustainable. The converse also applies: if railroads are profiting but the market is in a downturn, there is no clear trend.
5. Volume Must Confirm the Trend
Volume should increase if the price is moving in the direction of the primary trend and decrease if it is moving against it. Low volume signals a weakness in the trend. For example, in a bull market, the volume should increase as the price is rising, and fall during secondary pullbacks. If in this example the volume picks up during a pullback, it could be a sign that the trend is reversing as more market participants turn bearish.
6. Trends Persist Until a Clear Reversal Occurs
Reversals in primary trends can be confused with secondary trends. It is difficult to determine whether an upswing in a bear market is a reversal or a short-lived rally to be followed by still lower lows, and the Dow theory advocates caution, insisting that a possible reversal be confirmed.
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