November 1st, 2011

What is the Dow Theory?

I was alerted to the fact that November 3 will be the Charles Dow’s 160th birthday. The Market Technicians Association is celebrating the anniversary with a cocktail celebration.

We look at the gyrations of the market these days and think that it’s never been this bad. Some individual investors say that the stock market is rigged, have taken their money out of the market and pledge they will never come back. The claims of the Occupy Wall Street demonstrations are unique but assemblages on Wall Street have happened before.

For example, the Panic of 1907, also known as the 1907 Bankers’ Panic, was a U.S. financial crisis precipitating close to a 50% decline from its peak the previous year in most stocks on the New York Stock Exchange. The 1907 panic eventually spread throughout the nation causing businesses and many state and local banks to enter bankruptcy. The panic would have deepened if not for the intervention of financier J. P. Morgan, who pledged large sums of his own money and convinced other New York bankers to do the same to shore up the banking system. There was no central bank to inject liquidity back into the market as there is today.

It was around that time, that investors started looking for ways to sidestep the damage the market did to their portfolios. Within that context, Charles Dow wrote a series of articles outlining his views of market timing which ultimately collectively were given their eponymous name.

Most consider the father of technical analysis to be Charles Dow, the founder of Dow Jones & Company, the publisher of the Wall Street Journal. In a series of articles around 1900, Dow described his belief that markets represented by his creations, the Dow Jones Industrial Average and the Dow Jones Transportation Index, tended to move in similar ways over time. The articles were expanded later by other traders and ultimately became known as the “Dow Theory”. Although written over 100 years ago, the Dow Theory still has advocates and relevance due to its often being cited and referred in the business media today.

Dow Theory can be summarized in the following six tenets:

  1. The First Tenet is that markets move in one of 3 trends:
    • Up Trends are defined as when successive rallies close at levels higher than those of previous rallies and lows occur at higher levels than previous lows.
    • Down Trends are when the market makes successive lower lows and lower highs.
    • Corrections are defined as a move where the market recedes in a direction opposite of a move sharply in one direction before it continues in that original direction.
  2. The Second Tenet is that trends have 3 phases (a precursor of the theories of market life cycle and psychology described above):
    • The Accumulation phase which is when “expert” traders actively take positions actually opposite the majority of people in the market. Price does not change much during this phase as the “experts” are in the minority and so are not significant enough to move the market.
    • The Public Participation Phase which is when the public at large catches on to what the “experts” know and begins to trade in the same direction. Rapid price change can occur during this phase as everyone piles onto one side of a trade.
    • The Excess Phase is when rampant speculation occurs and the “smart money” starts to exit their positions.
  3. The Third Tenet is that the markets discount all news so that once a piece of news is released it is quickly reflected in prices. On this point Dow Theory is in line with the efficient market hypothesis.
  4. The Fourth Tenet is that the Industrials and Rails Averages must confirm each other; a sign that the market is going to change direction comes when two averages move in opposite directions.
  5. The Fifth Tenet is that trends are also confirmed by volume. There are many reasons why price may move on low volume, but when prices move on high volume there is a greater chance that the move is representative of the overall market’s view.
  6. The Sixth Tenet is that trends exist until definitive signals prove that they have ended. What Dow was saying here is that there will be market moves which are against the primary trend but this does not mean that the trend is over and the market will normally resume its prior trend.

Sometimes it pays to get away from complicated algorithms, indexes and formulas and just go back to the basics. I’m sure that Dow would found the current environment familiar albeit on a much larger scale. I wonder how he would have played this market?

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  • angel

    Great blog nice n useful information , it is very helpful for me , I realy appreciate thanks for sharing. I would like to read more information thanks.