Introduction to Dow Theory

What is Dow Theory?

Essentially, Dow Theory is a framework for technical analysis based on the work of Charles Dow on market theory. Dow was the founder and editor of The Wall Street Journal and co-founder of Dow Jones & Co. As part of the company, he helped create the first stock index, called the Dow Jones Transportation Average (DJT), followed by the Dow Jones Industrial Average (DJIA).

Dow never wrote down his ideas as a specific theory, nor did he refer to them in that way. Despite this, many people learned from him through the editorials of The Wall Street Journal. After Dow’s death, other editors such as William Hamilton refined these ideas and put his editorials together, which is now known as “Dow Theory”.

This article will specifically introduce Dow Theory and discuss the different stages of market trends based on Dow Jones’ work. As with other theories, the principles described below are not absolutely feasible and are only intended for open interpretation.

Basic principles of Dow Theory

Markets reflect everything

This principle is closely related to the so-called efficient market hypothesis (EMH). Dow believed that markets are reflective, meaning that all available information is already reflected in prices.

For example, if a company is widely expected to release earnings, the market will reflect this before the company officially releases its earnings report. The demand for the stock will increase before the company releases the report, and then the price may not change much after the expected positive report is finally released.

Dow pointed out that in some cases, a company may see a drop in its stock price after earnings because it did not perform as expected.

Many traders and investors, especially those who use technical analysis extensively, still believe that this principle is correct. However, those who prefer fundamental analysis disagree and believe that market values do not reflect the intrinsic value of stocks.

Market Trends

Some say that Dow’s work gave rise to the concept of market trends, which are now considered an important part of the financial world. Dow Theory believes that there are three main types of market trends:

Primary Trends — lasting from months to years, these are the most important market movements.

Secondary Trends — lasting from weeks to months.

Short-term Trends — tend to end in less than a week or no more than ten days. In some cases, they may only last for a few hours or a day.

By studying these different trends, investors can look for opportunities. While the primary trend is the one to prioritize and focus on, opportunities to profit often arise when secondary and short-term trends move in the opposite direction of the primary trend.

For example, if you believe that the primary trend of a cryptocurrency is upwards and the secondary trend is downwards, there may be an opportunity to buy it at a relatively low price and try to sell it after it increases in value.

Now the problem is to identify the type of trend you are observing, which is why more in-depth technical analysis is performed. Today, investors and traders use a variety of analysis tools to assist them in identifying the type of trend they are exploring.

Three Phases of Primary Trends

Dow divided long-term primary trends into three phases. For example, in a bull market, the three phases would be:

Accumulation — After the previous bear market, market sentiment is mainly negative and asset valuations remain low. This is when smart traders and market makers accumulate assets before prices rise significantly.

Massive retail participation — At this stage, the market will achieve more rapid growth, and as the opportunities observed by smart traders before, a large number of retail traders begin to actively buy. During this phase, prices rise rapidly.

Excess and Distribution — In the third phase, most traders continue to buy, but in reality, the uptrend is nearing its end. Market makers begin to sell off their holdings by selling shares to other participants who have not yet realized that the uptrend is about to change.

In a bear market, these phases are exactly the opposite. The trend will start with a sell signal, followed by a large number of retail investors participating in the sell. In the third phase, retail investors will continue to be pessimistic, but investors who can recognize that the market is about to turn will start accumulating again.

There is no guarantee that the principle will apply, but thousands of traders and investors consider these phases before taking action. It is worth noting that the Wyckoff theory is also based on the idea of accumulation and distribution, describing a similar concept of market cycles (transition from one phase to another).

Cross-index correlation

Dow believed that a major trend on a market index could be confirmed by a trend on another market index. At the time, this mainly involved the Dow Jones Transportation Average and the Dow Jones Industrial Average.

At the time, the transportation market (mainly railroads) was closely correlated with industrial activity. This makes sense: to produce more goods, railroad activity first needs to increase to provide the necessary raw materials.

Therefore, there is a clear correlation between the manufacturing and transportation markets. If one is healthy, the other is likely to be healthy as well. However, since many goods are digital and do not require physical delivery, the principle of cross-index correlation is not used much today.

Volume is important

Dow believed, as most investors do, that volume was a key secondary indicator, meaning that strong trends should be accompanied by volume. The higher the volume, the more likely the move reflects the true trend of the market. When volume is low, price action may not represent the true market trend.

Trends are valid until a reversal occurs

Dow believed that if the market is trending, it will continue to trend. For example, a company’s stock may start to rise after good news, and the stock price will continue to rise until there is a clear reversal signal.

Therefore, Dow believed that reversals should be viewed with skepticism until a primary trend is confirmed. Of course, it is not easy to distinguish between secondary trends and primary trend signals, and traders are often distracted by misleading reversal signals that ultimately turn out to be secondary trend signals.

Summary

Some people believe that Dow Theory is obsolete, especially in the context of cross-index correlation (the principle that one index or average can be supported by another index). Despite this, most investors still believe that Dow Theory is relevant to today’s markets. Dow’s work can not only be used to find trading opportunities, but also created the concept of market trends.

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