Notices

Dow Theory

From Traderpedia

Definition:
A theory which is based on the belief that the fluctuations in the stock market are both a reflection of current business trends as well as a predictor of future business trends.


Charles Dow prepared the foundation for what became known as Dow Theory, more than a century ago. The Dow Theory is the best known method of determining the major trends in the stock market. It also determines the type of trend, such as bull or bear.

Dow Theory is based on the assumption that the averages discount everything.

The fluctuations of the daily closing prices of the Dow-Jones rail and industrial averages afford a composite index of all hopes, disappointments and knowledge of everyone who knows anything of financial matters, and for that reason the effects of coming events (excluding acts of God) are always properly anticipated in their movement. The averages quickly appraise such calamities as fires and earthquakes.

[Rhea, R., The Dow Theory, Barron's, New York, 1932, p19.]

Dow Theory considers that market movements can be described in terms of the primary trend (the [[bull market}bull]] and bear markets which are measured in years), the secondary movements (which are measured in weeks to months) and daily fluctuations, which are of little significance. Secondary movements correct moves in the primary trend.

Charles Dow also addressed the issue of market phases in primary bull and bear markets. He divided a primary bull market into three phases:

A primary bull market is a broad upward movement, interrupted by secondary reactions, and averaging longer than two years. During this time stock prices advance because of a demand created by both investment and speculative buying caused by improving business conditions and increased speculative activity. There are three phases of a bull period: the first is represented by reviving confidence in the future of business; the second is the response of stock prices to the known improvement in corporation earnings, and the third is the period when speculation is rampant and inflation apparent - a period when stocks are advanced on hopes and expectations.

[Rhea, R., The Dow Theory, Barron's, New York, 1932, p13.]

He also divided a primary bear market into three phases:

A primary bear market is the long downward movement interrupted by important rallies. It is caused by various economic ills and does not terminate until stock prices have thoroughly discounted the worst that is apt to occur. There are three principle phases of a bear market: the first represents the abandonment of the hopes upon which stocks were purchased at inflated prices; the second reflects selling due to decreased business and earnings, and the third is caused by distress selling of sound securities, regardless of their value, by those who must find a cash market for at least a portion of their assets.

[Rhea, R., The Dow Theory, Barron's, New York, 1932, p13.]

According to Dow Theory, a bull trend is defined as a series of higher peaks and higher troughs. A bear trend is defined as a series of lower peaks and lower troughs. For Dow Theory to confirm a bull market, both the Dow Jones Industrial Average and the Dow Jones Transportation Average must be in bull trends. For Dow Theory to confirm a bear market, both the Dow Jones Industrial Average and the Dow Jones Transportation Average must be in bear trends. The closer these confirmations occur in time, the more significant the resulting move is likely to be.

Dow Theory also discusses accumulation and distribution. If a market moves within a range of about 5 per cent for several weeks or more, accumulation or distribution is taking place. If both averages subsequently break out above this 'line', the sideways movement was accumulation and prices should continue to rise. If both averages subsequently break out below this 'line', the sideways movement was distribution, and prices should continue to fall. A break by only one average is inconclusive.

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