The Dow theory is a financial markets theory developed by Charles H. Dow that rests on six basic tenets that were a precursor to modern-day technical analysis.
Charles Dow believed that the stock market as a whole was a reliable measure of global economic conditions and that by analysing the global market, it was possible to accurately assess those conditions to identify the direction of important market trends as well as the likely direction of individual stocks.
Dow theory explained
The Dow theory is based on the analysis of maximum and minimum market fluctuations to make accurate predictions on the direction of the market.
According to the Dow theory, the importance of these upward and downward movements is their position in relation to previous fluctuations. This method teaches investors to read a trading chart and to better understand what is happening with any asset at any given moment. With this simple analysis, even the most inexperienced can identify the context in which a financial instrument is evolving.
Furthermore, Charles Dow supported the common belief among all traders and technical analysts that an asset price and its resulting movements on a trading chart already have all necessary information already available and forecasted in order to make accurate predictions.
Based on his theory, he created the Dow Jones Industrial Index and the Dow Jones Rail Index (now known as Transportation Index), which were originally developed for the Wall Street Journal. Charles Dow created these stock indices as he believed that they would provide an accurate reflection of the economic and financial conditions of companies in two major economic sectors: the industrial and the railway (transportation) sectors.
Principles of Dow theory
For a better understanding of Charles Dow's writings and their implications, here are the six basic tenets that underpin the Dow theory.
One: the market discounts everything
Dow believed that the prices of stocks and indices reflected all available information and that anything that wasn’t reflected in the price was unknowable. This is known as the Efficient Market Hypothesis (EMH).
Two: the three-trend market
Dow theory highlights that primary trends tend to last for one year or more. They dictate whether a market is bullish (upward moving) or bearish (downward moving). Secondary trends are the corrective moves within a primary trend. They typically last between three weeks and three months, and lead to stock market corrections (a drop in stock prices) in a bull market and rallies (upticks in stock prices) in a bear market. Finally, there are minor trends that only last a matter of days and which are largely "market noise", in other words, unpredictable short-term fluctuations in stock prices.
Three: primary trends remain in effect until a clear reversal occurs
This is one of the more controversial elements of Dow theory. Indeed, reversals in primary trends can easily be confused with the emergence of secondary trends. Dow Theory therefore advocates caution and insists the primary trend remains in place until after the reversal is clear – which would take several months. This is one of the more controversial elements of the theory because a trader who follows it would miss out on the early stages of a new primary trend.
Four: the three phases of primary trends
The first phase of primary trends determines that informed investors profit from an accumulation phase (before a bull market) or a distribution phase (before a bear market). Traders then move towards a second public participation phase, which is when the largest price movement occurs. Finally, the market experiences a third excess phase, characterised by a period of euphoria (at the end of a bull market), or of panic/despair (at the end of a bear market).
Five: volume must confirm the primary trends
Volume should increase in the direction of the trend in order to give confirmation. It is only a secondary indication but Dow realised that if volume didn't increase in the direction of the trend, this is a red flag. This means that the trend may not be valid.
Six: primary trends must confirm each other across market indices
This last tenet, that two opposing primary trends cannot coexist on two different market indices, was undoubtedly the most important to Charles Dow. In other words, the primary trend discovered on a market index must always be confirmed by a similar trend on another market index and vice versa.
It was in response to this final tenet that Charles H. Dow did not stop at creating the Dow Jones Industrial Average. He also contributed to the development of another market index, the Dow Jones Transportation Average.
Dow theory trading strategy
Most trading strategies used today hinge on one key concept, the "trend". This was a novel idea when Charles H. Dow published his writings at the end of the 19th century. Dow theory says that the market is in an upward trend if one of its averages goes above a previous important high and is accompanied or followed by a similar movement in the other average. Therefore, a Dow theory trading strategy is based on a trend-following strategy, and can either be bullish or bearish.
Dow theory buy signal
A typical Dow theory buy signal would follow the below sequence:
After the low point of a downtrend in a bear market is established, a secondary uptrend bounce will occur.
A pullback on one of the averages must exceed 3% and then ideally hold above the prior lows on both the Industrial and the Transportation averages.
A breakout above the previous rally high would generate a buy signal for the developing bull market.
Dow theory sell signal
A typical Dow theory sell signal would follow the below sequence:
A bull market tops and sets back.
A subsequent rally goes back up over 3% and falls short of reaching the previous high.
A bear market sell signal is triggered when the rally penetrates the recent lows on the next fall, as measured by both the Industrial and Transportation averages.
Does Dow theory work?
Although a lot has changed over the past 100 years, the Dow theory and his six tenets are still applicable today and are considered a valid trading strategy by many traders. Much of what we currently know about technical analysis has its root in the Dow theory. This is why all financial operators using technical analysis should be familiar with the six basic principles of the Dow theory.