Dow Theory
Dow Theory is a general theory that attempts to describe the behavior of the stock market: the way that price trends develop and the reasons behind it. It also gives some ideas on how to determine whether a particular move should be seen as a continuation of the current trend or rather a sign of a trend reversal.
Main Principles of Dow Theory
Dow theory developed in the late 19th century by Charles Dow and some of its parts form the cornerstone of today's technical analysis.
This theory was used mainly in the analysis of two stock indices that Dow created, namely the Rails and the Industrials (which were simply the averages of the stocks of railroad and manufacturing companies) but it can be applied to individual stocks as well.
There are six main rules proposed by the theory:
- Stock averages discount everything
A very important tenet of Dow Theory is the claim that stock averages discount everything. It means that a stock price is a reflection of all market's knowledge and any new information is quickly incorporated. Once a piece of news is published, stock prices change to reflect this new information. What is more, current price also represents investors' expectations for the future and takes into consideration any possible future scenarios. - The market has three trends
Before we begin discussing different types of trends, let us state explicitly what Dow considered a trend: an uptrend is a series of rising price peaks and troughs while a downtrend is a series of falling peaks and troughs. - Dow distinguished three different trend types:
1) Primary (or major ) trend (compared by Dow to the ocean tides) may last from one to several years. It can be bullish or bearish and is considered the most important among the three types.
2) Secondary trend (compared by Dow to the waves in the tide) which is a correction in the primary trend, may last from three weeks to three months and generally retraces from 33% to 66% of the previous trend movement.
3) Minor trend (compared by Dow to the ripples) represents fluctuations in the secondary trend and lasts usually less than three weeks. - Market trends have 3 phases.
These phases take part in both an uptrend and a downtrend. Let us consider a bullish market. The phases are as follows:
1) Accumulation phase represents informed buying by the most knowledgeable and shrewd investors who believe that all pessimistic information has its reflection in the prices and the turning point is near.
2) Public Participation Phase is the phase where most trend-following investors enter the market. Prices start to rise rapidly in this phase and the general economic news becomes more optimistic.
3) Distribution phase is connected with the third wave of investors - the general public that - due to the optimistic market news that has become ubiquitous - begin to buy on the presumption that the current trend will continue. They are encouraged by the media (that start publishing more and more bullish stories) and the general investment ambiance which is better than ever. They are usually individual investors with small experience. In this phase that very same informed investors who begun buying in the first place, begin to sell before anyone else starts.
Let us now turn to the bear market:
1) Distribution phase - the bear market begins usually where the bull market ends. This phase could be described exactly the same way as above.
2) Panic selling phase is - as the name suggests - best characterized by panic and fear. As prices start to decline and buyers become scarce, people desperately want to exit the market, which usually leads to a very sharp drop in price.
3) Discouragement phase takes place when the steepest declines are over and usually means a stabilization in the economy. Investors who held their stocks, in hope that the market would recover, sell their portfolios discouraged by the situation. Also people who bought just after the sharpest fall in price, hoping for the rally, are selling, discouraged by the fact that these rallies are not sustained and prices continue to decline further. Discouragement phase may be followed by a long horizontal range, but sooner or later things begin to look brighter and a new accumulation phase takes place. - Trends are confirmed by volume
Dow believed that volume should confirm price trends (i.e. it should expand in the direction of the current trend), but volume analysis in Dow Theory is not as significant as price analysis. Bullish trend is confirmed by volume when it increases as the price goes up and decreases when the price goes down. Conversely, a downtrend is confirmed by volume when it expands as the price falls and it diminishes when the price rises. - Stock market averages must confirm each other
The averages originally referred to in this point are the Rails and the Industrials discussed at the beginning. Dow believed that only if both averages gave a bullish or bearish signal, it was considered important. The signals from both averages did not have to take place simultaneously but the shorter the time span between them the stronger the signal was considered. It is especially important when it comes to the beginning of a new trend or a trend reversal, as Dow believed that a divergence between the averages should be interpreted as the continuation of the prior trend. - Trends exist until definitive signals prove that they have ended
What this tenet says, is that the odds favor a trend continuation. It might be viewed as an analogy to a physical law that a body in motion remains in that motion until stopped or forced to change the direction by an external force. Dow believed that the longer the trend lasts, the greater the probability of its change, yet one should not take action until a definite confirmation of a trend reversal takes place.
Dow Theory and Gold
Dow theory forms a general description of market behavior. Hence, it can be applied to the analysis of assets other than stocks, such as precious metals. Below we can see how it works in practice when used on the gold market:
On this chart we can see only the two first phases of the bull market in gold, since the third one has not begun yet. It is believed that the first phase began between 2000 and 2002 and lasted until 2006, and the second one began in 2006. That was the time, when gold broke out of its trading range in Euro and stayed above previous resistance long enough to attract new capital. One might argue whether this is precise time when the second stage of this bull market began (some prefer to think of the breakout date as the exact beginning) or not, but choosing this date also stems from the fact that the beginning of 2006 was the moment when prices of precious metals reached important levels: $550 for gold and $10 for silver. Once these milestone were achieved, the price accelerated and peaked a few months later.
Conclusion
Dow theory is a general theory that describes the behavior of the stock market. As we have seen, it can be applied to virtually everything traded on a stock exchange, not only to stocks. This is not a theory attempting to produce perfect buy and sell signals, yet it does provide investors with basic rules and ideas about the functioning of the market, and could be helpful in general understanding of the way it works.
Moreover, it seems to have passed the test of time, as some ideas are still as valid now as they were over 100 years ago, and the theory's influence on technical analysis (definition of a trend, ideas used to construct stock indicators, divergences, market indices, etc.) is clearly visible nowadays.
However, it should be remembered that throughout this period lots of things have changed. With the advent of super-fast computers and the Internet, the markets have become much more globalized and interconnected than they used to be when this theory came into being. Thus, in the contemporary markets, the short term and ultra short-term trends are of much more importance than when this theory was born.