Dow Theory

Section 7, Lecture 9
Modern Technical Analysis and Dow Theory
The practice of technical analysis in some forms were present for many centuries
but Charles Dow (18511902) was the first to reintroduce and comment on it in
recent times.
Charles Dow developed Dow Theory while working with the Wall Street Journal back
in 1897. Robert Rhea refined by further refined the theory in 1932, and later S.A.
Nelson and William Hamilton improved the theory into what it is today. The ideas
put forward by these men have become foundation of todays Technical
Analysis. There are six basic tenets of Dow Theory, and they are as follows
1. The Averages Discount Everything Dow hypothesized that prices discounted
everything, including expectations, to the point that they are predictive of events.
He put forward this concept where he explained as new information arrives, market
participants quickly disseminate the information and the price adjusts accordingly,
similarly, the market averages discount and reflect everything known by all stock
market participants.
2. The Market Is Comprised of Three Movements Dow identified three types of
price change in the market. These changes are simultaneously present in the
market. These changes are known as Primary, secondary and minor movements

Primary movements These movements represent the broad underlying

trend. These actions are typically referred to as BULL or BEAR trends.

Secondary movements These movements run counter to the primary trend

and is reactionary in nature. In a bull market, a secondary movement is known as a
correction and in a bear market, secondary moves are called reaction rallies or bear
market rally.

Minor movements These are short-term movements lasting from one day to
three weeks. Secondary trends are typically comprised of some Minor trends.
3. Primary Trends Have Three Phases In this theorem, Dow postulated that
there are three Stages of Primary Bull Markets and Primary Bear Markets.
In the bull market, the first phase is made up of aggressive buying by informed
investors in anticipation of economic recovery and long-term growth. The first stage

of a bull market is known as Accumulation Phase. The Second phase is

characterized by increasing corporate earnings and improved economic conditions.
This Phase of a primary bull market is usually the longest, and sees the largest
advance in prices and most commonly known as Movement With Strength Phase.
The Third phase is characterized by record corporate earnings and peak economic
conditions. This period is marked by Marked by excess speculation and the
appearance of inflationary pressures and termed as Excess Phase.
In the bear market, the first phase starts when smart money managers begin to
realize that business conditions are not quite as good as once thought, and thus
they begin to sell the stock. This phase is characterized by a moderate decline in
prices which is followed by is a reaction rally that retraces a portion of the decline.
This phase is known as Distribution Phase.The second phase of the bear market
starts when the trend has been identified as down, and business conditions begin to
deteriorate. This phase is termed as Movement With Strength Phase and provides
the largest move. The third and final phase of a bear market starts when all hope is
lost, and stocks are frowned upon.
This phase is called Despair phase. In this phase, valuations are low, but the
selling continues as participants seek to sell no matter what. The news from
corporate are bad, the economic outlook is bleak. The market continues to decline
but at a lower pace.
4. The Averages Must Confirm Each Other Dow emphasized that for a primary
trend or sell signal to be valid, both the Dow Jones Industrial and The Transport
averages must confirm each other.
Dow considered a rally in the industrial average should be accompanied by a rally in
the railway averages too, thus confirming the bull market. The logic behind this
hypothesis was fundamental, because if the industrial rally then it suggests that
manufacturing profits are up then it means consumer spending is up.
This creates a chain of demand for goods, so manufacturers are producing more
goods to full fill the needs. To supply the goods, the manufacturers must transport,
in this case, use railways as the mode of carrying goods to consumers.
In order to confirm significant trend one must consider two averages or indices ,
when these two indices (In case of Dow Theory these two indices were industrial

and the railroads index) move in tandem then only one could confirm that a major
trend is in place.
5. The Volume Confirms the Trend The Dow Theory primarily focuses on pricing
trends, however, to confirm uncertain situations volume is only used. The theory
states that the volume should increase along with the price in the direction of the
major trend. If the primary trend is down, then volume should increase during falling
market. If the primary trend is up then, volume should increase during rising
market.
6. A Trend Remains Intact Until It Gives a Definite Reversal SignalThis
theorem relates a physical law to market movement; it is an adaptation of Newtons
First Law of motion. This Theorem posited that an object in motion (in this case a
trend) tends to continue in motion until some external forces cause it to change
direction.
In other words, an uptrend is defined by a series of higher highs and higher-lows.
For an up-trend to reverse, prices must have at least one lower high and one lower
low then the reverse is true for a downtrend.