By Jane Fox*
On July 3, 1884, Charles Dow published the first stock market average, composed of the closing prices of 11 stocks: Nine railroad companies and two manufacturing firms. Dow felt that these 11 stocks provided a good indication of the economic health of the country. In 1897, Dow determined that two separate indices would better represent that health and created a 12-stock industrial index and a 20-stock rail index.
The idea came to life when industrial production and railroads were the two staples of American economic growth. Although seemingly different, they were both important pieces to one puzzle. After all, if goods were being produced in factories, they also had to be shipped. This was a win-win situation for production and rail transport. If demand for goods dropped, factories slowed production. And, if factories produced less, the rail carriers suffered from a lack of demand for their services. That was a lose-lose scenario. By 1928, the industrial index grew to its current size of 30 stocks.
Dow never wrote a book on his theories but set down his ideas of stock market behavior in a series of editorials that The Wall Street Journal published around the turn of the century. In 1903, the year after Dow's death, S.A. Nelson compiled these essays into a book called the The ABC of Stock Speculation and coined the phrase "Dow Theory." Richard Russell, who wrote the introduction to a 1978 reprint, compared Dow's contribution to stock market theory to Freud's contribution to psychiatry.
Basic Dow Theory Tenets
1. The averages discount everything.
"The sum and tendency of the transactions of the stock exchange represent the sum of all Wall Street's knowledge of the past, immediate and remote, applied to the discounting of the future. There is no need to add to the averages, as some statisticians do, elaborate compilations of commodity price index numbers, bank clearings, fluctuations in exchange, volume of domestic and foreign trades or anything else. Wall Street considers all these things." (Hamilton, pp. 40 - 41)
What this is saying is that the market reflects every possible knowable facet that affects supply and demand and discounts it all. The theory applies to market averages, as well as to individual markets, and even makes allowances for acts of God (or exchanges going down) by not anticipating them but almost instantaneously assimilating their effects into the price action.
2. The market has three trends.
In Dow theory, an uptrend is successive higher highs and higher lows; a downtrend is successive lower highs and lower lows, which is the cornerstone of technical analysis. "Records of trading show that, in many cases, when a stock reaches a top, it will have a moderate decline and then go back again to near the highest figures. If, after such a move, the price again recedes, it is liable to decline some distance." I think he just described a head and shoulders.
Dow then considered a trend to have three parts -- Primary, Secondary and Minor -- which can be compared to the tide, then the waves that make up the tide and, finally, the ripples making up the waves. You can see the direction of the tide my looking at the highest point on the beach reached by each successive wave. If each wave is reaching higher on the beach, the tide is coming in; if each successive wave reaches a lower spot than the previous one, the tide is going out.
Dow determined that the direction of primary trends (tides) could last for several years, whereas the secondary trend (a correction within the larger trend) usually lasted three weeks to three months and, most frequently, retraced 50% of the previous move. Dow also stated that these retracements could be 1/3 or 2/3, which I see relating to Fibonacci analysis very nicely.
3. Major trends have three phases.
Dow theory states that the primary trend (the tide) has three phases: Accumulation, public participation and distribution. If the previous trend was bearish, the bullish trend will start with the accumulation phase represented by informed buying by the most astute buyers because they have recognized that the market has assimilated all the so-called "bad" news.
The public participation phase is where most of the technical trend followers begin to participate, and prices begin to advance rapidly. The distribution phase takes place when the newspapers begin to print increasingly bullish stories, economic news is better than ever and speculative volume increases. It is during this phase that the informed investors begin to distribute before anyone else.
4. The averages must confirm each other.
Dow theory says that no important bull or bear market signal could take place unless both averages (industrial and transportation) confirmed one another by giving the same signal. Both averages must exceed a previous secondary peak to confirm the inception or continuation of a bull market. He did not believe the signals had to occur simultaneously but recognized that a shorter length of time between the signals provided a stronger confirmation.
The theory, then, is that the two indices should behave in tandem. Typically, one leads the other, but the lagger shouldn't be far behind. It is widely accepted that the transportations are more apt to lead because factories and capital goods producers make shipping arrangements well in advance (sometimes even before they have actually made the goods they're going to ship). Assuming a stable business cycle, they should even both make new highs and new lows in almost perfect synchronization. (Again, the theory says that one typically leads the other slightly.) As long as this is happening, forecasting the general direction of stocks is fairly transparent.
5. Volume must confirm the trend.
Dow theory says that volume is important but secondary. Simply stated, volume should expand or increase in the direction of the major trend.
6. A trend is assumed to be in effect until it gives a definite signal that it has reversed.
This tenet relates to the physical law that states that a body in motion tends to stay in motion until some external force causes it to change direction. But, what constitutes a change in direction?
A number of technical tools are available to traders to assist in the difficult task of spotting reversal signals, including the study of support and resistance, price patterns, candlestick patterns, trendlines, moving averages, etc. And, here is where the molasses get really thick: Is the move we are currently in a correction of the prior move or a reversal (i.e., Is the tide now moving out instead of in)?
Although Dow theory has stood the test of time, it has not gone without criticism. A Dow signal usually occurs in the second phase of a trend as price penetrates a previous intermediate peak. This is also, incidentally, about where most trend-following technical systems begin to identify and participate in the existing trends. In all fairness, though, Dow never intended to anticipate trends. Rather, he sought to recognize the emergence of major bull or bear markets and capture the middle portion of important moves.
An understanding of Dow theory provides a solid foundation of a study of technical analysis, whether it be trendlines, support and resistance, candlesticks or just plain price patterns. The standard definition of a trend, the classification of a trend into three categories and phases, the principles of confirmation and the use of percentage retracements all derive in one way or another from Dow theory.
*This article is reprinted from www.optioninvestor.com with modifications and permission.
