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Explaining Dow Theory - Does it Deliver Results?

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Dow theory stands out as one of the most revered theories in the history of financial markets. Whether you're engaged in intraday trading, short-term trading, or long-term investment, understanding this theory is bound to help you formulate diverse strategies.

Originally crafted by Charles Dow in the late 1800s, Dow Theory, also known as Dow Jones Theory, has stood the test of time. Charles Dow, the founder of the Dow-Jones financial news service WSJ (Wall Street Journal) and Dow Jones and Company, developed this trading strategy.

Even after a century, Dow theory remains influential and is considered one of the most sophisticated studies in technical analysis.

I trust this will be beneficial to anyone involved in trading or investing in financial markets.

What is the essence of Dow Theory?

In an article published in the Wall Street Journal on January 31, 1901, Charles H. Dow likened the stock market to the ebb and flow of ocean tides.

He stated, "A person observing the rising tide and wishing to determine the precise moment of high tide places a stick in the sand at the points reached by the incoming waves until the stick reaches a position where the waves no longer reach it and eventually recede enough to indicate that the tide has turned." This approach proves effective in monitoring and predicting the rising tide of the stock market.

Dow believed that analyzing the current state of the stock market could offer insights into the current state of the economy.

Indeed, the stock market can serve as a valuable gauge for understanding the underlying reasons behind upward and downward trends in both the economy and individual stocks.

How Does the Dow Theory Operate?

The Dow Theory operates based on several principles, which include the following:

1. The Averages Account for Everything:
Market prices incorporate all known or unknown factors that may impact supply and demand. It is believed that the market reflects all available information, including information not yet public. This encompasses various events such as natural disasters like droughts, cyclones, floods, or earthquakes.

Major geopolitical occurrences, trade conflicts, domestic policies, elections, GDP growth, fluctuations in interest rates, and earnings forecasts or anticipations are all already factored into market prices. While unforeseen events may arise, they typically influence short-term trends while leaving the primary trend intact.

2.The Market Exhibits Three Trends:

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a)The primary trend:

This trend can extend from one year to several years and represents the dominant movement of the market. It is commonly known as either a bull or bear market. The bullish primary uptrend sees higher highs followed by higher lows, while the bearish primary downtrend witnesses lower highs and lows.

The challenge lies in predicting when and where these primary trends will conclude. The goal of Dow Theory is to leverage known information rather than making speculative guesses about the unknown. By adhering to Dow Theory guidelines, one can identify and align with the primary trend.

b)The intermediate trend or secondary trend:

This trend typically lasts from 3 weeks to several months and is characterized by reactionary movements. In a bull market, these movements are viewed as corrections, whereas in a bear market, they are seen as rally attempts.

For instance, during a primary uptrend, a stock may retrace from its high to establish a low (known as an intermediate trend or correction). Conversely, in a primary downtrend, a stock might experience a temporary rebound after a prolonged decline (known as bear market rallies).

c)The minor trend or daily fluctuations:

This trend, lasting from several days to a few hours, is the least reliable and is often disregarded according to Dow Theory. Long-term investors should perceive daily fluctuations as part of the corrective process within intermediate trends or bear market rallies.

These fluctuations represent the noise in the market and can be susceptible to manipulation. While daily price action is important, its significance lies in the context of the broader market structure.

Analyzing daily price movements over several days or weeks can provide valuable insights when viewed alongside the larger market picture. While individual pieces of the structure may seem insignificant, they are integral to completing the overall picture.

3.Major Trends Comprise Three Phases:
Dow focused extensively on major trends, identifying three distinct phases within them: Accumulation, Public participation, and Distribution.

These phases occur cyclically and repeat over time.

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a) Accumulation Phase:

This phase occurs when the market is in a bearish trend, characterized by negative sentiments and a lack of hope for an upcoming uptrend. For instance, we witnessed steep declines in mid-cap stocks in the Indian share market, with new lows being made frequently.

While many investors anticipate this trend to persist indefinitely, this is actually when significant investors, such as large fund houses and institutional investors, begin gradually accumulating these stocks.

This period is known as "smart money" investing for the long term. Despite ongoing selling pressure in the market, buyers are readily found.

b) Public Participation Phase:

During this phase, the market has already absorbed the negativity, with "smart money" investing. This marks the second stage of a primary bull market and typically sees the most significant rise in prices.

At this point, the majority of the public (retail investors) also considers joining in as prices rapidly increase. However, many are left behind due to the speed of the rallies and the upward trend in averages.

Traders and investors may experience regret for not participating in the rally. This phase follows improved business conditions and increased stock valuations.

c) Distribution Phase:

The third stage represents excess, eventually transitioning into the distribution phase. In this final stage, the public (retail investors) becomes fully engaged in the market, captivated by the bull market rally.

Some investors who previously felt left out may still seek opportunities to join the rally based on valuations.

However, this is when "smart money" begins to sell off shares at every high point. Meanwhile, the public attempts to buy at these levels, absorbing the selling volumes from large investors.

In the distribution phase, whenever prices attempt to rise, "smart money" unloads their holdings.

This marks the onset of a bear market, where sentiments turn negative, bankruptcy filings increase, and economic growth shifts.

During a bear market, frustration levels rise among retail investors as hope dwindles.

4.Confirmation Between Averages is Essential:

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Dow used to say that unless both Industrial and Rail(transportation) Averages exceed a previous peak, there is no confirmation or continuation of a bull market.
Both the averages did not have to move simultaneously, but the quicker one followed another – the stronger the confirmation.
To put it differently, observe the image above, as you can see both the averages are in bull market, trending upward from Point A to C.

5.Confirmation of Trends Through Volume:
Volume serves as a metric indicating the amount of shares traded within a specific timeframe, aiding in trend and pattern analysis.
According to Dow theory, a stock's uptrend should be supported by high volume and exhibit low volume during corrections.
While volume data alone may not be comprehensive, integrating it with resistance and support levels can provide a more comprehensive understanding.

6.Trend Persistence Until Clear Reversal Signals:
Similar to Newton's first law of motion, which states that an object will remain at rest or in uniform motion unless acted upon by an external force, market trends are expected to persist until a significant external force, such as changes in business conditions, prompts a reversal.
Signs of trend reversals become apparent when impending changes in trend direction are observed.

7.Signal Recognition and Trend Identification:
A significant challenge in implementing the Dow theory is accurately identifying trend reversals. Adhering to the Dow theory requires not only assessing the overall market direction but also recognizing definitive signals of trend reversals.
A key technique employed in identifying trend reversals within the Dow theory is analyzing peaks and troughs, or highs and lows. Peaks represent the highest points in a market movement, while troughs signify the lowest points.
According to the Dow theory, markets do not move in a linear fashion but rather oscillate between highs (peaks) and lows (troughs), with overall market movements trending in a particular direction.
An upward trend in Dow theory consists of a series of progressively higher peaks and troughs, while a downward trend is characterized by progressively lower peaks and troughs.

8.Market Manipulation:
Charles Dow believed that manipulation of the primary trend was improbable, while short-term trading, including intraday movements and secondary movements, could be susceptible to manipulation.
Short-term movements, ranging from hours to weeks, may be influenced by factors such as large institutions, speculators, breaking news, or rumors, potentially leading to manipulation.
While individual securities may be manipulated, such as artificially driving up prices before reverting to the primary trend, manipulating the entire market is highly unlikely due to its vast size.
Why Dow Theory Is Not Foolproof:
Dow Theory is not a fail-safe method for outperforming the market, as it is not without its flaws. Critics argue that it lacks the depth and precision of a formal theory.

Conclusion:
Understanding the Dow Theory enables traders to identify hidden trends that may elude more seasoned investors, empowering them to make informed decisions about their positions.
The Dow theory aims to pinpoint the primary trend and capitalize on significant movements. Given the market's susceptibility to emotion and tendency for overreaction, the goal is to focus on identifying and following the prevailing trend.

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