The essentials about The Dow Theory

Dow Theory is inevitably the provenance of the technical analysis . It was formulated from a series of Wall Street Journal editorials authored by Charles H. Dow from 1900 until the time of his death in 1902. Dow’s beliefs on how the stock market behaved and how the market could be used to measure the health of the business environment were represented by his newspaper columns..

The Dow Jones Industrial Index and the Dow Jones Rail Index (now Transportation Index) are based on the Dow theory developed by Charles Dow, which were originally formulated by him for The Wall Street Journal. Dow created these indexes because he believed Railways and Industry  were an accurate reflection of the business conditions within the economic system. While these indexes have changed over the last 100 years, the theory still touches on current market indexes.

The theory consists of six tenets which are essentials to the Dow Theory.

• The Averages Discount Everything:The idea that the markets reflect every possible knowable factor that affects overall supply and demand is on the basic premises of technical theory. The theory applies to market averages, as well as it does to individual markets, and even makes allowances for “acts of God” like earthquake, floods etc.
• The market Has Three Trends: The market consists of uptrend and downtrend. Each trend mas three parts called the primary trend, secondary trend and daily fluctuations. A primary trend is any any major trend which lasts from a few months to a few years. The secondary trend is generally counter to a primary trend and lasts for a time period ranging from a few weeks to a few months. Example if the primary trend is Bullish then the secondary trend is Bearish. The daily fluctuations or near term trends usually lasts less than three weeks. This near term trend represents fluctuations in the secondary trend.
• The primary Trends Have Three Phases:The uptrend has first the Accumulation Phase, the Public Participation Phase, and the Distribution phase.The downtrend has the Distribution Phase, the Public Participation phase and the Panic Phase.
• The Averages Must Confirm Each Other:Dow, in referring to the Industrial and rail Averages, meant that no important bull or bear market signal could take place unless both averages gave the same signal, thus confirming each other.
• Volume Must Confirm the Trend:Dow recognized volume as a secondary but important factor in confirming price signals. Simply stated, volume should expand or increase in the direction of the major trend. In a major uptrend, volume would then increase as price move higher, and diminish as prices fall. In a downtrend, volume should increase as prices drop and diminish as they rally.
• A Trend Is Assumed to Be in Effect Until It Gives Definite Signals That It Has Reversed: This tenet forms much of the foundation of modern trend-following approaches. It relates a physical law to market movement, which states that an object in motion (in this case a trend) tends to continue in motion until some external forces causes it to change direction.

Though the Dow theory is germane in nature and meat and potatoes of the Technical Analysis, it has a few criticism in its kitty as well. The brickbats are as follow:

• Not Really A Theory: Dow did not write proper academic papers outlining the theory and testing the theorems. The ideas of Dow were put forth through his columns in the Wall Street Journal.
• Being Too Late:The trend does not change from bearish to bullish until the previous reaction high has been surpassed. Many traders feel that this is simply too late and misses much of the move.
• Outdated: The Dow theory is criticized as being outdated and no longer gives an accurate reflection of the economy.The sectors like IT, Pharmaceuticals etc have also robust the stock market.

In the true essence of technical analysis, Dow Theory marked its leadership for the past century and continues to do so. It has given birth to concept of Elliot Wave and has wide relevance till date.

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