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What is the 'Dow Theory'

The Dow theory is a theory which says the market is in an upward trend if one of its averages (industrial or transportation) advances above a previous important high and is accompanied or followed by a similar advance in the other average. For example, if the Dow Jones Industrial Average (DJIA) climbs to an intermediate high, the Dow Jones Transportation Average (DJTA) is expected to follow suit within a reasonable period of time.

BREAKING DOWN 'Dow Theory'

The Dow theory is an approach to trading developed by Charles H. Dow who, with Edward Jones and Charles Bergstresser, founded Dow Jones & Company, Inc. and developed the Dow Jones Industrial Average (DJIA). Dow fleshed out the theory in a series of editorials in the Wall Street Journal, which he co-founded.

The theory has undergone further developments in its 100-plus-year history, including contributions by William Hamilton in the 1920s, Robert Rhea in the 1930s, and E. George Shaefer and Richard Russell in the 1960s. Aspects of the theory have lost ground, for example, its emphasis on the transportation sector — or railroads, in its original form — but Dow's approach still forms the core of modern technical analysis.

There are six main components to the Dow theory. They are summarized briefly here:

1. The market discounts everything. The Dow theory operates on the efficient markets hypothesis (EMH), which states that asset prices incorporate all available information. In other words, this approach is the antithesis of behavioral economics. Earnings potential, competitive advantage, management competence — all of these factors and more are priced into the market, even if not every individual knows all or any of these details. In more strict readings of this theory, even future events are discounted in the form of risk.

2. There are three kinds of market trends. Markets experience primary trends which last a year or more, such as a bull or bear market. Within these broader trends, they experience secondary trends, often working against the primary trend, such as a pullback within a bull market or a rally within a bear market; these secondary trends last from three weeks to three months. Finally, there are minor trends lasting less than three weeks, which are largely noise.

3. Primary trends have three phases. A primary trend will pass through three phases, according to the Dow theory. In a bull market, these are the accumulation phase, the public participation (or big move) phase and the excess phase. In a bear market, they are called the distribution phase, the public participation phase and the panic (or despair) phase. 

4. Indices must confirm each other. In order for a trend to be established, Dow postulated, indices or market averages must confirm each other. Dow used the two indices he and his partners invented, the Dow Jones Industrial Average (DJIA) and the Dow Jones Transportation Average (DJTA), on the assumption that if business conditions were in fact healthy, as a rise in the DJIA might suggest, the railroads would be profiting from moving the freight this business activity required. If asset prices were rising but the railroads were suffering, the trend would likely not be sustainable. The converse also applies: if railroads are profiting but the market is in a downturn, there is no clear trend.

5. Volume must confirm the trend. Volume should increase if price is moving in the direction of the primary trend, and decrease if it is moving against it. Low volume signals a weakness in the trend. For example, in a bull market, volume should increase as the price is rising, and fall during secondary pullbacks. If, in this example, volume picks up during a pullback, it could be a sign that the trend is reversing as more market participants turn bearish.

6. Trends persist until a clear reversal occurs. Reversals in primary trends can be confused with secondary trends. It is difficult to determine whether an upswing in a bear market is a reversal or a short-lived rally to be followed by still lower lows, and the Dow theory advocates caution, insisting that a possible reversal be confirmed.

For a more in-depth look into this concept, read the tutorial on Dow Theory.

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