Loading the player...

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.

RELATED TERMS
  1. Ripple

    Ripple is a term used to conceptualize the day-to-day fluctuations ...
  2. Market Average

    A market average is a measure of the overall price level of a ...
  3. Dow Jones U.S. Total Market Index

    The Dow Jones U.S. Total Market Index is a market-capitalization-weighted ...
  4. Dow Jones Asian Titans 50 Index

    Dow Jones Asian Titans 50 Index is a market capitalization-weighted ...
  5. New Growth Theory

    New growth theory is a concept that presumes the desire and wants ...
  6. Entity Theory

    Entity theory is the assumption that the economic activities ...
Related Articles
  1. Investing

    Giants of Finance: Charles Dow

    Find out how financial visionary Charles Dow helped everyday people enter the world of finance.
  2. Investing

    Dow Theory Gores Stock Market's Bears

    Bear Hunting: The Dow Jones Transportation Average's new high is a bullish indicator
  3. Investing

    How Does The Dow Jones Work?

    In this article find out how the Dow Jones Industrial Average works, tracks market movements, and what changes mean for investors and the stock market.
  4. Trading

    The Pioneers of Technical Analysis

    Every time an investor talks about entry and exit points, they are paying homage to these men.
RELATED FAQS
  1. When can you trade the stocks in the Dow Jones Industrial Average (DJIA)?

    Find out when you can trade shares linked to the Dow Jones Industrial Average during NYSE and Nasdaq trading sessions. Read Answer >>
  2. When did the Dow Jones Industrial Average (DJIA) begin?

    Discover how the Dow Jones Industrial Average, first published in 1896, was created as a way to inform investors of the overall ... Read Answer >>
  3. What is the Dow Jones Industrial Average (DJIA) all-time high?

    Inching ever higher, the Dow Jones recorded new highs in May 2015. Since the index was first calculated in 1896, it has grown ... Read Answer >>
  4. Why is the Dow Jones Industrial Average (DJIA) price weighted?

    Learn how the Dow Jones Industrial Average has told the story of the broad market through its simple, price-weighted calculation ... Read Answer >>
  5. Where can I find all of the stocks in the Dow Jones Industrial Average?

    The Historical Components List is the best place to learn about all 30 stocks in the Dow Jones Industrial Average. Read Answer >>
Trading Center