The Basic Tenets of the Dow Theory

The Dow Theory is a theory of stock market analysis that relies on the performance of the Dow Jones Industrial Average (DJIA) and the Transportation averages. The theory was formulated by Charles H. Dow through a series of editorials in the Wall Street Journal over a two-year period from 1900–1902. The writings documented Dow’s beliefs regarding the behavior of the stock market and its use as an indicator of the current phase of the business cycle. Today, the Dow Theory provides an operating model for technical investors.

The Six Basic Tenets of the Dow Theory

The Market Discounts Everything: Under the first basic premise, all news and information is quickly incorporated into a stock price as soon as that information becomes available. Under this tenet, Dow Theory supports the efficient market hypothesis (EMH).

The Three-Trend Market: The Dow Theory leverages trend analysis to identify the overall direction of the market. The theory defines three movements: The Primary Trend is the major movement of the market. This trend can last for several years. The Secondary Trend or “intermediate trend” serves as a correction to the primary movement, moving in the opposite direction of the primary movement. The Minor Trend is a corrective move within the secondary trend and is typically defined as lasting less than three weeks.

Market Trends Have Three Phases: This tenet further describes the primary trend by identifying three phases of that trend. The Accumulation Phase marks the beginning of an upward trend. This phase comes at the end of a downward trend as investors re-enter the market to buy stocks at attractive prices. The Public Participation Phase follows as informed investors enter the market and help to drive up stock prices. The Excess Phase completes the cycle as savvy investors to scale back their positions believing that the market is becoming over-priced.

Stock Market Averages Must Confirm Each Other: The Dow Theory states that a major reversal in trends is not signaled unless the major averages (Industrial and Railway) are in agreement. Without agreement in these averages, it is difficult to confirm a trend in business conditions.

Trends Are Confirmed by Volumes: Under Dow Theory, only price movements accompanied by high trading volumes can represent the investors’ current view of the market. Absent high trading volumes, there can be a number of explanations for price changes.

Trends Exist Until Definitive Signals Mark the End: While markets might make a temporary move in one direction or the other, Dow Theory requires significant evidence to mark the end of a trend. One of the primary goals of technical analysis is to identify these reversals to react accordingly.

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The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.

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