Dow Theory Explained
What is the Dow Theory?
Dow Theory, a form of technical analysis, focuses on the movement of stock prices and incorporates
aspects of sector rotation. It originated from 255 Wall Street Journal editorials penned by Charles H.
Dow (1851–1902), the journalist who founded the Wall Street Journal and co-founded Dow Jones and
Company. After Dow’s death, his concepts were organised and presented collectively as “Dow Theory”
by William Peter Hamilton, Robert Rhea, and E. George Schaefer. It’s important to note that Dow never
referred to his ideas as “Dow Theory” nor did he present them as a trading system or strategy.
The 6 Principles of Dow Theory
Hamilton, Rhea, and Schaefer reviewed and summarised Dow Theory into six key principles:
1. The Market has Three Movements:
- Main Movement: The major trend, lasting from less than a year to several years, can
be upward or downward. - Medium Swing: The secondary or intermediate trend lasts from ten days to three
months, generally retracing a third to two-thirds of the main movement. - Short Swing: Minor movements last from a few hours to a month or more. All three
movements can occur simultaneously, such as a daily short swing within a medium
swing that reacts to a bullish main movement.
2. Market Trends have Three Stages:
- Accumulation Phase: Informed investors start buying or selling, going against the
general market sentiment. - Public Participation Phase: The broader market notices the trend, leading to rapid
price changes as more participants join. - Distribution Phase: Early investors begin to sell off their holdings as speculation
becomes rampant.
3. The Market Discounts All News: Share prices quickly reflect new information, aligning with
the efficient market hypothesis. Once news is released, prices adjust to incorporate this new
data.
4. Stock Market Averages Must Confirm Each Other: Dow’s industrial and rail averages must
move in the same direction. If industrial profits rise, distribution (rail) companies should also
show strength. Diverging averages signal a potential market change.
5. Trends are Confirmed by Volume: Volume validates price trends. Low-volume price
movements may be due to temporary factors, while high-volume movements reflect true
market sentiment. Strong volume in the direction of a price change indicates a developing
trend.
6. Trends Persist Until Definitive Signals Indicate Reversal: Trends continue despite temporary
market noise. Reversals should be given the benefit of the doubt. Determining if a reversal is
a new trend or a correction can be challenging, and technical analysis tools may offer varying
interpretations.
Understanding Dow Theory’s Impact
Initially, the profitability of Dow Theory was questioned, as a diversified buy-and-hold strategy seemed
more effective. However, recent studies suggest that Dow Theory can generate excess risk-adjusted
returns. One major critique is the lack of specific trading rules, requiring assumptions and
interpretations. Despite this, many technical analysts consider Dow Theory’s focus on trends and price
action fundamental to modern technical analysis.