The Dow theory is another form of technical analysis. It deals in price movement coupled with some parts of sector rotation. The theory was compiled from the articles written by its namesake. Charles H. Dow founded the Wall Street Journal, which he wrote for, and the Dow Jones and Company. He had two other partners, Edward Jones and Charles Bergstresser. Charles Dow never adopted the Dow theory while he was alive. Instead, after his death, his articles were organized and presented as the Dow theory.
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What Is Dow Theory?
What is the Dow theory? The theory 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. In other words, if one average moves up in price, the other will follow within a reasonable time frame.
The stock market is a tug-of-war between buyers and sellers. That’s one of the stock trading basics.
As a result, the market trades in cycles. There will be pullbacks and corrections. Those keep everything from becoming overvalued. Think about it; the average trader couldn’t afford to trade without corrections. Every stock would be too expensive.
So, while bear markets or corrections can be painful to the investor, they’re necessary. They also don’t last as long as bull markets, especially in the current world with unlimited stimulus or quantitative easing. That’s where you can implement the Dow theory.
If you want to know whether or not the market is in an uptrend, look at the industrial or transportation Dow averages. If one of those has a previous high that’s broken to make a new one, look at the other average. There should be a similar advance as well.
As a result, the uptrend is confirmed. 6 components make up the Dow theory. We’ll take a look at those below.
Discounts
The market discounts everything. As a result, the Dow theory uses something known as the efficient markets hypothesis. That means that stock prices incorporate all available information.
Even if the average trader doesn’t know everything there is to know about a stock, a bunch of factors are accounted for and priced into the market. Things like earnings potential, competitive advantages, and the competence of management. In other words, fundamental analysis is important in the market’s price action. Fundamental analysis is also something not every trader pays attention to.
There are fundamental traders and technical traders. One isn’t better, and one way isn’t right or wrong.
Market Trends
There are three kinds of market trends. The Dow theory is all about trend confirmation. There are strong trends like the bull market and bear market. They’re major because they can last a year or more. We can have a bull market or bear market that lasts a long time.
In the big trends, there are secondary ones as well. The secondary trends typically go in the opposite direction of the big trend in place. They can be pullbacks in a bull market or rallies in a bear market.
They can last a week up to a couple of months. As a result, make sure you’re trading safely and watching the patterns. If you invest long-term, you don’t want to buy stocks based on a short-term trend.
Then there are the minor trends. These are just noise and don’t last more than a few weeks. These minor moves can be a reaction to a larger move that happens.
In other words, there are large trends. Within those large trends are secondary trends that go against the primary trend. Then, within those secondary trends are minor trends. The Dow theory helps to confirm all types of trends.
What Is the Dow Theory Sell Signal?
What is the Dow Theory sell signal? As market sentiment catches up to them, phase 2 starts. Price changes quickly because technical analysis is changing along with the trend. Phase 3 starts when speculation begins, and investors distribute their holdings to the market. Because the Dow theory is about trends, a trend must be confirmed. As a result, for a trend to be established, market indicators must confirm each other. Hence, this is the reason for the Dow Jones Industrial Average and the Dow Jones Transportation Average.
If one average is trending up, but the other one doesn’t follow, the trend is weak. For a trend to be strong, both averages must complement each other in their moves.
Volume is another confirmation. Volume has to increase with the direction of the trend. If the price is moving but volume is decreasing, then the trend is weak.
Phases of Dow Theory
According to the Dow theory, there are three phases within a primary trend. They’re not the same as the different trends within the primary trend. There’s the accumulation phase, the public participation phase, and the distribution phase.
The accumulation phase occurs when investors actively buy or sell against the general outlook. As a result, the price doesn’t change much because these investors are in the minority.
Final Thoughts on Dow Theory
The Dow theory is all about trends. Since there are three different types of trends in the Dow theory, strong reversal signals are needed to confirm the reversal of the trend. As a result, look at technical indicators, candlesticks, and patterns to help get confirmation of a changing trend.
