Modern technical analysis has come a long way over the years. But some investors still like to use
the old school approaches in their analysis. One of the first and oldest schools
of technical analysis is Dow Theory. The theory came from the collected works of
Charles Dow, who first published his observations in the Wall Street Journal over 150 years ago.
Dow Theory attempts to time entries and exits in the stock market by analyzing price trends,
volume, and other characteristics. Dow Theory consists of six ideas.
The first idea is that a market tends to move in one of three ways.
The most influential move is the primary trend, which may last several months to several years.
Investors using Dow Theory try to align their portfolios with the primary trend.
The next type of market move is a secondary trend that runs counter to the primary trend.
A secondary trend might last anywhere from 10 days to three months and it usually loses
between a third and two-thirds of the value gained during the primary trend.
The third type of move is a short swing, which might last for a few hours to a month.
Charles Dow referred to these moves as noise, meaning they were insignificant.
The second idea of Dow Theory is that primary trends have three phases.
The first phase is known as accumulation. This is when insiders buy stocks toward
the tail end of a downward trend in anticipation of a new upward trend.
The second phase is known as public participation. This is when a new upward trend accelerates,
attracting trend followers and other technically driven investors.
The third phase is known as distribution. This final phase is when insiders sell to the public
after an upward trend has grown speculative.
The third idea of Dow Theory is that stock prices react quickly to news. As a result, stock prices
reflect new information almost immediately. The fourth idea of Dow Theory
involves the relationship between the Dow Jones Industrial and Transport Indices.
Charles Dow created these indices to represent what he believed were the
most important industries in the economy, namely manufacturing and transportation.
The Dow Industrials are composed of manufacturing businesses and the
Transports are composed of railroads, airlines, trucking, delivery, and shipping businesses.
Both of these indices tend to move in the same direction.
But when these indices move apart, it could be a sign that the market will reverse its trend.
The fifth idea of Dow Theory is that volume must confirm trends. Charles
Dow believed that relatively high volume was necessary to confirm primary trends.
The sixth idea of Dow Theory is that trends exist until definitive signals prove otherwise.
Charles Dow believed that a primary trend should be given the benefit of the doubt.
Combining the six ideas of Dow Theory gives investors a framework for organizing
information in the financial markets. Some investors use the theory to help
them decide when to buy and sell stocks. For example, an investor using Dow Theory
might decide to hold on to an existing portfolio of stocks after observing a
convergence between the Dow Industrials and Transports, as both jumped to reach
new highs. Investors might use this convergence to identify bullish, or uptrending, markets.
Conversely, Dow Theory can be used to identify bearish, or downtrending,
markets as well. An investor using the theory might sell a portfolio of stocks
after observing the Dow Industrials and Transports making new lows. This investor considers this a
sell signal and might use it to exit a portfolio of stocks in an effort to limit losses.
Critics of Dow Theory point out that it’s not technically a strategy for investing,
but instead a collection of subjective rules. For example, one investor might interpret a
market move as a primary trend, where another investor would only see a secondary trend.
Additionally, Dow Theory can be late in identifying reversals.
Some investors might notice that sell signals arrive well after a reversal is underway.
A final criticism is that Dow Theory is outdated because it focuses on Industrials and Transports.
Some investors believe that these industries do not reflect the modern economy.
Despite its critics, many investors still follow Dow Theory