Introduction to Dow TheoryThe Dow Theory is the core of contemporary technical research. Its premises have stood the test of time and underpin the study of market behavior research. The basic principles of Dow Theory and their importance in today's markets will be discussed in this article.
Origins and History of the Dow Theory
Many of the early studies that contributed to what is now known as Dow Theory is credited to Charles H. Dow. Dow's successor, William P. Hamilton, continued to establish and organize many of Dow's initial early publications, including the Wall Street Journal editorials written at the turn of the twentieth century. Robert Rhea, a Hamilton student, was later responsible for categorizing, refining, and formal codifying Dow's fundamental principles, which were set out in Rhea's book The Dow Principle.
In 1884, Dow reported an 11-stock stock market average, which he later extended into a 12-stock Industrial Index and a 20-stock Railroad Average. Instead of attempting to gauge market activity by individual stock movement, Dow decided to build an index of stocks that would better represent the aggregate action of the markets. The averages' movement was intended to serve as a barometer of the overall business environment. Since then, the 12-stock Industrial Index has morphed into the Dow Jones Industrial Average, which now contains 30 stocks.
Market trends according to Dow Theory
Robert Rhea explains in this book that three distinct patterns are considered to prevail in the market according to Charles H. Dow.
1. Primary trend – that lasts from months to years
2. Secondary reaction (intermediate trend) – weeks to months in duration
3. Short term trend – days to weeks
The Primary trend
The primary pattern is by far the largest, and it is typically predicted to last months to years. Main trends, according to Rhea, are less vulnerable to distortion and therefore provide a more accurate indicator for investment decisions. There are 2 types of primary trends: primary bull trend and primary bear trend . An uptrend is described in Dow Theory as a series of successively higher highs and lows. The concept "downtrend" refers to a sequence of lower highs and lows.
Primary trends have 3 phases. A primary bull or bear trend consists of these 3 phases:
a) Accumulation phase
b) Trending phase
c) Distribution phase
Accumulation usually happens after a sharp and fast drop in values, usually as a result of companies releasing extremely negative results. At this point, the uninformed market participants are normally incredibly bearish, selling whatever shares they have left at any amount. Market investors who are well informed and trained continue to buy shares at incredibly low levels.
The uptrend and downtrend phases make up the trend process.
After a sustained and dramatic rise in prices, distribution usually occurs. Both newspapers and news reports are extremely bullish, and businesses appear to outperform. Uninformed market traders are prone to being too bullish, buying up whatever shares are available in the market at any expense, a condition known as excessive exuberance. Margin debt is at an all-time high. During the distribution process, smart investors begin to liquidate shares steadily, taking care not to push down rates too fast so that they can continue to sell at higher prices.
The secondary trend or reaction
The secondary trend or reaction moves or reacts in the opposite direction of the existing primary trend. It normally lasts a few weeks to three months, but it can last a little longer in some cases. The secondary reaction typically retraces one-third to two-thirds of the spectrum of the primary trend. Any retracement or reversal of more than two-thirds of a percent on big volume typically suggests that the secondary response is a new primary bear market. Dow Theory further emphasizes the value and psychological meaning of the 50% retracement stage, which is a viewpoint held by another influential technician, W. D. Gann.
The minor trend
Minor patterns aren't taken into account in Dow Theory. “The stock market is not rational in its fluctuations from day to day,” Hamilton wrote in his book The Stock Market Barometer. Minor patterns will last anywhere from a few days to a few weeks.
Trade with care.
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