Dow Theory is a method for picking successful stock trades. At over a hundred years old, it may be the oldest system for selecting stocks that is still utilized. This is why investors often refer to it as the grandfather of stock selection theory.
Charles Dow created his Dow Theory in a series of Wall Street Journal editorials he wrote from 1900 to 1902. He laid down the basic fundamentals of his theory in these articles. They explained how the stock markets worked. Charles Dow also created two of the main indexes for the stock markets that the markets still use today. These are the Dow Jones Industrial Average and the precursor to the Dow Jones Transportation Index (the Dow Jones Rail Index). Charles died in 1902. His death left this work to be completed by other followers who published several books on the subject over the next sixty years.
Dow Theory is still important to markets and investors today. People study the theory to understand how several of the main indexes work. Investors also have created a number of systems based on Dow Theory over the years as well. The principles of technical analysis are rooted in Dow Theory ideas. Technical analysis centers on reading charts. These technicians use information in the charts to predict future stock prices.
Six basic ideas underpin Dow Theory. Some investors have attempted to discount these concepts over the years. Over time they generally prove to be true despite the skeptics.
The first one states that the market considers all information with its price levels. This means that stock prices reflect past, present, and even future information. The market takes everything into account including inflation, interest rates, soon to be released earnings announcements, the emotions of investors, and even future event risk.
The second idea says that three trends make up the market actions. These include primary trends, secondary trends, and minor trends. The primary trends usually last over a year. Secondary trends hold for several weeks to several months. They run counter to primary trends. Minor trends occupy less than three weeks.
The third Dow Theory concept claims that three main phases make up the primary trends. The accumulate phase starts the market prices moving up. The mass participation phase is where average investors buy into the market and drive prices significantly higher. This is the longest lasting phase in any market. The excess phase is where the market becomes overbought. Bigger, more knowledgeable investors begin to sell their shares to new investors ahead of a downturn in this phase.
A fourth idea states that two market indexes must agree on the trend change. It is not just any two indexes that have to concur. Bull markets and bear markets only switch when the Dow Industrial average and Dow Transports average agree together on the change in the trend.
Dow Theory’s fifth tenet is that volume confirms the trend. Volume represents the number of shares that change hands. Without major volume appearing on any significant move against a trend, the trend is usually still intact. Volume should be greater when price is moving in the direction of the trend. When price goes against the trend, volume should be less.
The final idea of Dow Theory claims that a trend continues until there is a clear reversal. It requires overwhelming evidence to convincingly reverse the trend. Trading against the trend will usually hurt investors. This makes the popular statement “the trend is your friend” more than just a catchy stock market slogan. It also proves to be a significant philosophy behind Dow Theory.