Dow Theory

What is it & how can it be applied to the stock market?


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Hi, after numerous requests in the comments section, In this video we take a quick look at Dow Theory and how it can be helpful in identifying trends and reversals.


The Dow Theory was developed by Charles H. Dow, who was one of the co-developers of the DowJ ones Industrial Average in 1886. He published the theory through a series of articles in the Wall Street Journal, which he co-founded along with Edward Jones and Charles Bergstresser.


Unfortunately, Dow couldn’t complete the entire theory due to his death in 1902, and the theory was therefore expanded and completed by his associates and followers’ years after his death.


There are six main tenets of the Dow Theory


The first tenet of the Dow theory states that The market discounts everything.


The Dow Theory states that the market is efficient and discounts everything known to the general public. In a stricter interpretation of the theory, the markets even discount future events. 


If Dow Theory is to be believed, it’s impossible to beat market returns, without exposing oneself to higher risk. As per the theory, all available information is already built into stock prices, and neither expert stock selection or market timing can help anyone outperform the market returns.


The second tenet of the Dow Theory states that there are Three kinds of market trends.

The first is a primary trend that lasts a year or more, such as a bull or a bear market. Within the primary trend, there are intermediate, secondary trends that are formed against the primary trend like a pullback or short-term correction.


The duration of secondary trends can be between three weeks and

three months. Then there are minor trends that last less than three weeks and are considered noise.


The third tenet of Dow Theory states that the primary trends have three phases

The primary market trends go through three phases before they reverse. In an uptrend, the markets see an accumulation phase, a public participation phase, and an excess phase.


In a downtrend, the markets see a distribution phase, a public participation phase, and a despair phase.


As we enter this current period, we are certainly in or heading for the despair phase. For me however, this is a great time to be adding to long term positions, but only into well diversified funds, not singular stocks.


The fourth tenet of Dow Theory states that Indices Must Confirm Each Other

As per the Dow Theory, a trend gets established when all the major indices or market averages move in tandem. If the major indices point in opposite directions, the trend is not conclusive, and traders should be cautious.


Dow used two indices, namely, Dow Jones Industrial Average and Dow Jones Transportation Average to prove the tenet. The theory was, that if the economy was indeed healthy as indicated by the DJIA, the railroads should profit and the DJTA, which formed of railroad stocks should also move in tandem

with the DJIA.

For me, this part of the theory is now outdated.


The fifth tenet of Dow Theory is that Volume Must Confirm the Trend.

As per the Dow Theory, the trading volume should increase when the price is moving in the direction of the primary trend. So, for example, if the index is in an uptrend, the volume should be higher when the index is moving up and lower when it’s moving down.


If price moves in the direction of the primary trend with lower volumes, then it’s assumed that the trend is not strong, and a reversal might happen.

This part of the theory still holds true today, whether it is the direction of trend or a breakout trade, the volume should also be aligned to the move.


The sixth tenet of Dow Theory is that Trends Persist Until a Clear Reversal Occurs

As per the theory, a trend is considered to be in force until a clear reversal occurs. Investors and traders must understand how to identify reversals and how to differentiate them from secondary trends. 


Also referred to today as technical analysis, this part of the theory refers to the breaking of support or channel lines.


Let’s now understand how to interpret and implement Down Theory.


A follower of Dow Theory trades only in the direction of the trend, therefore it becomes necessary to understand how to determine which trend is in force and how to identify the reversal as it happens.


Dow suggested peak and trough analysis to determine the direction of the trend. In this analysis, price is said to be in an uptrend if it’s hitting higher highs and higher lows.

On the other hand, the trend is said to be reversed when the price fails to reach new highs and breaches previous low levels, making lower highs and lower lows.


The downtrend is deemed to be in place if the price keeps on hitting lower lows and making lower highs. The downtrend reverses when the price breaches the previous high and makes a lower low.


The theory can be used to identify the trends and reversals in individual securities as well as in broader markets. It gives a bird’s eye and microscopic view of the direction of the trend, which is of great help to a trend-chasing trader or investor.  


Let’s now understand some limitations of the Dow Theory.


The Dow theory was formulated in the 1900s using the structure of the economy and the market indices at that time. It’s been more than a century since the theory was formulated and the structure of the market and underlying economy has completely changed over time. For example, the US market

has moved away from industrials to technology companies, rendering the industrial indices like DJTA non-existent and unusable. 


The other limitation of the theory is the emphasis on the efficient market hypothesis in its first tenet.

There have been many examples of active managers beating the market returns through expert stock selection and market timing, which is a complete contrast to the theory.


If you invest enough time and develop the right skills, it is indeed possible to beat the market returns in the long run.


Summing it up, the Dow theory, due to its simplicity, is a potent tool for traders and investors who need a simple theory to determine the direction of the trend. It’s easy to interpret and works well in all time frames. 


I loosely use the theory, although prefer using moving averages to determine the trend.

 

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