Dow Theory

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



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.