By Chad Langager and Casey Murphy, senior analyst of ChartAdvisor.com
The first basic premise of Dow theory suggests that all information - past, current and even future - is discounted into the markets and reflected in the prices of stocks and indexes.
That information includes everything from the emotions of investors to inflation and interest-rate data, along with pending earnings announcements to be made by companies after the close. Based on this tenet, the only information excluded is that which is unknowable, such as a massive earthquake. But even then the risks of such an event are priced into the market.
It's important to note that this is not to suggest that market participants, or even the market itself, are all knowing, with the ability to predict future events. Rather, it means that over any period of time, all factors - those that have happened, are expected to happen and could happen - are priced into the market. As things change, such as market risks, the market adjusts along with the prices, reflecting that new information.
The idea that the market discounts everything is not new to technical traders, as this is a major premise of many of the tools used in this field of study. Accordingly, in technical analysis one need only look at price movements, and not at other factors such as the balance sheet. (For more on this, see The Basics Of Technical Analysis.)
Like mainstream technical analysis, Dow theory is mainly focused on price. However, the two differ in that Dow theory is concerned with the movements of the broad markets, rather than specific securities.
For example, a follower of Dow theory will look at the price movement of the major market indexes. Once they have an idea of the prevailing trend in the market, they will make an investment decision. If the prevailing trend is upward, it follows that an investor would buy individual stocks trading at a fair valuation. This is where a broad understanding of the fundamental factors that affect a company can be helpful.
It's important to note that while Dow theory itself is focused on price movements and index trends, implementation can also incorporate elements of fundamental analysis, including value- and fundamental-oriented strategies.
Having said that, Dow theory is much more suited to technical analysis.