The Dow Theory: A History

7.8

8 ratings

6,294 views

Article
Beginner
3

Henry To

25 Feb, 2007

in Technical Analysis and 1 more

Charles H. Dow
It is interesting and amazing to note that not until Charles Dow started compiling the Dow Jones Industrial and Dow Jones Rail Index and started writing about the stock market a little over a hundred years ago, stock speculation was regarded merely as a game for the rich or as gambling for the brave. Sure, there were the tape readers, but the majority of the public regarded Wall Street as a source of excitement - the entertainment provided freely (unless you were on the wrong side) by figures such as Cornelius Vanderbilt, Jay Gould, and the infamous Daniel Drew.

In a series of stunning editorials for the Wall Street Journal at the turn of the century, Dow laid out the foundation of his own theory on the stock market. Among them were:

  • The market is always to be considered as having three movements, all going on at the same time.
  • The first thing to consider is the value of the stock in which the speculator proposes to trade, the second the direction of the main movement, and the third the direction of the secondary movement (i.e. stocks fluctuate together, but prices are controlled by values in the long run).
  • There are three phases to both a primary bull market and a primary bear market (not to be confused with the three movements mentioned above).
  • The formation of a "line" in the averages indicates accumulation or distribution
  • The market represents a serious well-considered effort on the part of far-sighted and well-informed men to adjust prices to such values as exist or which are expected to exist in the not too remote future.

The method of making money in stocks, according to Dow, was to study basic conditions and exercise enough patience to capture the major movements. One of the few speculators who discovered this relatively new concept of making money on Wall Street at the time was Jesse Livermore. He was able to accomplish this only through trial and error and the making and losing of several fortunes.

William P. Hamilton
William P. Hamilton, Dow's understudy and the fourth editor of the Wall Street Journal, continued Dow's legacy after his death in 1903. The Dow Theory as interpreted by Hamilton forms the basis of all modern technical analysis today. He wrote about the Dow Theory for the Wall Street Journal for more than 20 years. His additions to the Theory included:

  • The Averages discount everything
  • The primary trend cannot be manipulated
  • Both the Industrials and Rails (the modern day Transports) must confirm each other in order for the signal to have authority
  • The Theory is not infallible. If someone did find such a system, then he
    or she will own the world in relatively short order and speculation as we know it will not exist.
  • Determining the trend by spotting "higher highs" or "lower lows"

Hamilton's predictions of the trends were uncannily accurate, even as he developed a wide following from his editorials. A major reason why he was accurate almost all the time was his lack of a writing schedule - choosing only to write when he had something to say about the market, sometimes going for weeks without writing a single word.

The one significant time when he erred was in late 1925 and early 1926 when he erroneously labeled a serious secondary reaction in a primary bull market as a bear market. Followers of Hamilton lost heavily during that period, as the market bottomed out in March 1926 (Industrials 135.20 and Rails 102.41) and was getting ready to resume its long advance that would not end (tragically) until September 1929.

Even so, Hamilton would always be remembered for penning the following editorial on October 25, 1929, just days before the crash. His words proved prophetic - calling for the beginning of a new primary bear market. Part of his now-famous editorial is reproduced below:

A Turn in the Tide - October 25, 1929
On the late Charles H. Dow's well known method of reading the stock market movement from the Dow-Jones averages, the twenty railroad stocks on Wednesday, October 23 confirmed a bearish indication given by the industrials two days before. Together the averages gave the signal for a bear market in stocks after a major bull market with the unprecedented duration of almost six years. It is noteworthy that Barron's and the Dow-Jones NEWS service on October 21 pointed out the significance of the industrial signal, given subsequent confirmation by the railroad average.

Hamilton passed away six weeks after he wrote the above editorial. It is a
tragedy that probably not a great number of people at the Wall Street Journal or Barron's today have even heard of the Dow Theory, let alone have a complete understanding of it.

Robert Rhea
The next great Dow theorist, Robert Rhea, initially stumbled upon the Dow Theory during his endeavor to find "a system" for helping him make money in the stock market. In his attempts to disprove the theory, he became a convert. Rhea was a very serious student, and he was able to utilize the Dow Theory as interpreted by Hamilton to his advantage, buying and holding stocks in 1921, and basically holding them until late 1928 (he reversed his short position when he realized Hamilton's advice was incorrect in early 1926), missing only the final blowoff phase. He also "played" the short side successfully during the subsequent deflation. In 1932, he began publishing his newsletter based on the Dow Theory, called the "Dow Theory Comment."

You need to be logged in to post comments or rate this article.

nice abstract.

I missed a short explanation about what Dow theory can do for u in real live.

4 phases r describing investors behaviour acting,pausing,acting,pausing

Mar 01, 2007

Member (900 posts)

A very very good article
a pity I cannot print in full page 1 and 2 to keep for my future reference
page 3 was a complete ok to print is it my computer and printer or T2W ?
twiglet

Feb 28, 2007

Member (206 posts)

T2W Bot
This is a forum thread for discussing the Knowledge Lab Article, "The Dow Theory: A History".


It is "manic-depressive" - Benjamin Graham

Feb 28, 2007

Member (18 posts)

Loading...