By Chad Langager and Casey Murphy, senior analyst of ChartAdvisor.com

There is little doubt that Dow theory is of major importance in the history of technical analysis. Many of its tenets and ideas are the basis of much of what we know today. Aspects of Dow theory are also incorporated into other theories, such as Elliott Wave theory. (To learn about this concept, see Elliott Wave Theory and Elliott Wave In The 21st Century.)

However, since its original adaptation and subsequent updates, its relevance as a stand-alone analytical technique has weakened. The reason for this has been the advent of more advanced techniques and tools, which in part build off of Dow theory, but greatly expand upon it.

One of the bigger problems with the theory is that followers can miss out on large gains due to the conservative nature of a trend-reversal signal. As we mentioned previously, a signal is confirmed when there is an end to successive highs (uptrend) or lows (downtrend). However, what often happens is that by the time the market has shown a clear sign of reversal, the market has already generated a large gain.

Another problem with Dow theory is that over time, the economy - and the indexes originally used by Dow - has changed. Consequently, the link between them has weakened. For example, the industrial and transportation sectors of the economy are no longer the dominant parts. Technology, for example, now takes up a considerable portion of economic production and growth.

This is important because the basis for watching the indexes is that they are the leading indicators of business conditions. The economy has clearly become more segmented, requiring the analysis of more indexes, which could greatly reduce the accuracy and timeliness of Dow theory analysis. Imagine having to look at six indexes while still adhering to Tenet #4: Indexes Must Confirm Each Other.

Even though there are weaknesses in Dow theory, it will always be important to technical analysis. The ideas of trending markets and peak-and-trough analysis are found constantly within technical writings and ideas. Also of importance in Dow theory is the idea of emotions in the marketplace, which remains a characteristic of market trends.

Charles Dow and Dow theory helped investors improve their understanding of the markets so that they could maker better investments and achieve investment success.

Next: Dow Theory: Conclusion »


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