In 1897, Charles Dow developed two broad
market averages. The "Industrial Average" included 12 blue-chip stocks and the
"Rail Average" was comprised of 20 railroad enterprises. These are now known as
the Dow Jones Industrial Average and the Dow Jones Transportation Average. The
Dow Theory resulted from a series of articles published by Charles Dow in The
Wall Street Journal between 1900 and 1902. The Dow Theory is the common ancestor
to most principles of modern technical analysis. Interestingly, the Theory
itself originally focused on using general stock market trends as a barometer
for general business conditions. It was not originally intended to forecast
stock prices. However, subsequent work has focused almost exclusively on this
use of the Theory.
Interpretation
The Dow Theory comprises of six assumptions:
1. The Averages Discount Everything.
An individual stock price reflects everything
that is known about the security. As new information arrives, market
participants quickly disseminate the information and the price adjusts
accordingly. Likewise, the market averages discount and reflects everything known
by all stock market participants.
2. The Market Is Comprised of Three Trends.
At any given time in the stock market, three
forces are in effect: the Primary trend, Secondary trends, and Minor trends. The
Primary trend can either be a bullish (rising) market or a bearish (falling)
market. The Primary trend usually lasts more than one year and may last for
several years. If the market is making successive higher-highs and higher-lows
the primary trend is up. If the market is making successive lower-highs and
lower-lows, the primary trend is down. Secondary trends are intermediate,
corrective reactions to the Primary trend. These reactions typically last from
one to three months and retrace from one-third to two-thirds of the previous
Secondary trend. Minor trends are short-term movements lasting from one day to
three weeks. Secondary trends are typically comprised of a number of Minor
trends. The Dow Theory holds that, since stock prices over the short-term are
subject to some degree of manipulation (Primary and Secondary trends are not),
Minor trends are unimportant and can be misleading.
3. Primary Trends Have Three Phases.
The Dow Theory says that the First phase is
made up of aggressive buying by informed investors in anticipation of economic
recovery and long-term growth. The general feeling among most investors during
this phase is one of "gloom and doom" and "disgust". The informed investors,
realizing that a turnaround is inevitable, aggressively buy from these
distressed sellers. The Second phase is characterized by increasing corporate
earnings and improved economic conditions. Investors will begin to accumulate
stock as conditions improve. The Third phase is characterized by record
corporate earnings and peak economic conditions. The general public (having had
enough time to forget about their last "scathing") now feels comfortable
participating in the stock market--fully convinced that the stock market is
headed for the moon. They now buy even more stock, creating a buying frenzy. It
is during this phase that those few investors who did the aggressive buying
during the First phase begin to liquidate their holdings in anticipation of a
downturn.
In anticipation of a recovery from the
recession, informed investors began to accumulate stock during the First phase.
A steady stream of improved earnings reports came in during the Second phase,
causing more investors to buy stock. Euphoria set in during the Third phase, as
the general public began to aggressively buy stock.
4. The Averages Must Confirm Each Other.
The Industrials and Transports must confirm
each other in order for a valid change of trend to occur. Both averages must
extend beyond their previous secondary peak (or trough) in order for a change of
trend to be confirmed. Confirmation of the change in trend occurred when both
averages rose above their previous secondary peak.
5. The Volume Confirms the Trend.
The Dow Theory focuses primarily on price
action. Volume is only used to confirm uncertain situations. Volume should
expand in the direction of the primary trend. If the primary trend is down,
volume should increase during market declines. If the primary trend is up,
volume should increase during market advances.
6. A Trend Remains Intact Until It Gives a
Definite Reversal Signal.
An up-trend is defined by a series of
higher-highs and higher-lows. In order for an up-trend to reverse, prices must
have at least one lower high and one lower low (the reverse is true of a
downtrend). When a reversal in the primary trend is signaled by both the
Industrials and Transports, the odds of the new trend continuing are at their
greatest. However, the longer a trend continues; the odds of the trend remaining
intact become progressively smaller.
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