Any investor, expert or novice, who has been in the market must have heard a term used by many, which signals what trend the market is in, that popular term is the “The Dow Theory”. While the term baffles many, it makes perfect sense to some.
The theory was derived from 255 Wall Street Journal editorials written by Charles H. Dow (1851–1902), journalist, founder and first editor of the Wall Street Journal and co-founder of Dow Jones and Company. The popular Dow Jones Industrial Average (DJIA) also has its roots from the same.
Following Charles Dow’s death, William Peter Hamilton, Robert Rhea and E. George Schaefer organized and collectively represented “Dow Theory,” based on Dow’s editorials. It is amusing that Charles Dow never used the term Dow Theory nor did he use it as a trading system.
Dow Theory, put in the simplest form states that all the stocks in the market move in a trend. It could be an upward trend or a downward trend. There are some basic tenets of Dow Theory which help us understand the system better and use it to our advantage.
The Six basic tenets of Dow Theory can be understood as given:
- The three movements: Dow stated that the market action can be represented by the movement the stock price makes on the charts. He compared the stock movement to waves in the ocean. Any stock would move in 3 types of ways viz. Primary movement, Secondary movement and Tertiary movement. The primary movement or wave is the overall trend the stock or the market is in. It can be compared to a Tide in the ocean. The primary trend may last from several months to several years. The primary wave consists of a number of secondary waves just as the tide consists of small waves. The secondary trend may last from 3 weeks to 3 months. The final and the most insignificant trend is the tertiary which is the daily movement in the stock price much like the ripples in the sea.
- Accumulation and Distribution phases: Each stock can be in the accumulation phase, frenzy phase and distribution phase. Astute investors accumulate the stock when the rest of the market is quiet. As the rest of the market participates, we see heavy buying and a lot of frenzies. Smart investors distribute it at the top as the stock later heads for frenzy selling.
- The average discounts everything: It is assumed that any news pertaining to stock is already factored into the stock price. The average or the index discounts every such news.
- The averages must conform each other. The US stock market had the Industrials index and the Railroad index. Dow Theory states that sooner or later, both the indices move in sync. The averages must conform each other or else, the trend is not confirmed.
- Volume moves with price: Any change in the stock price must be confirmed with the change in volume. Any divergence in the price and volume action must be looked at with suspicion. The price must move with the volume.
- Trend exists until we see reversal: The trend in stock continues to exist until and unless we see clear indications of a trend reversal. The intermediate movement is just the market noise and must be ignored.
Although the Dow Theory was formed almost a century ago, the principals still hold. We may see a lot of critics of the Dow Theory disregarding its validity. But an astute investor must have an open mind and try to analyse what investing pattern suits them the best.