Dow Theory: Everything You Need to Know

There are plenty of techniques that investors and traders alike can use to find positions for their portfolios. From simple value screens to more rigid systems like CANSLIM, these methods can be used to find stocks and other assets to buy. The hope is that the investor’s method will help guide their decision making towards big profits and take the emotion out of the markets. One of the oldest practices is Dow Theory.

By looking at technical analysis and price action, as well as market philosophy and sentiment, investors can use Dow Theory to uncover various stages of the market and profit from the trends. Dow Theory isn’t hard to understand or use, but it does take some basic knowledge to use it right.

Dow Theory Basics

Dow Theory began as a series of editorials in the Wall Street Journal nearly 100 years ago. Charles Dow developed the Dow Theory from his analysis of market price action in the late 19th century. He noticed several relationships between both the transportation—at the time just rail—and industrial averages. William Hamilton later refined Dow’s work in the 1920s, and in 1932, Robert Rhea took Dow Theory one step further and analyzed the nearly 250 different editorials written by the two men.

Through his book, “The Dow Theory,” Rhea gave birth to the concept’s modern understanding and set forth the various assumptions essential to the model. Rhea was also the first person to actually use and coin the term Dow Theory to describe the method for stock market fluctuations.

The Major Assumptions

For Dow Theory to work, investors need to familiarize themselves with several major assumptions of the markets and the model. These points are critical to understanding how the relationships between the various indexes, stocks and market movements are related.

Manipulation: While it is possible to manipulate indexes and stocks over a single day, it is impossible to manipulate the primary trend of the market over longer periods of time. Investors recognizing the primary trajectory of the market can ignore the day-to-day movements to prosper.

Stocks Discount All News: The current price of a stock represents the total of all the hopes, fears and expectations of all owners with regards to that stock. Basically, stocks are fairly priced based on all that is known about that company today. That means any unknown news will cause the stock to move accordingly.

The Theory Is Not Perfect: Both Hamilton and Dow in their writings have basically come out and said that the Dow Theory is not necessarily a sure-fire means of beating the market. Major events—such as the Lehman Brothers Bankruptcy or the September 11th terrorist attacks—can completely shift the model to its side. However, over most normal market cycles, the theory is quite sound and can used to predict movements.

The Indexes Must Confirm Each Other: Dow Theory is as much about the strength of the economy as it is about individual stocks. To that end, Charles Dow postulated that in order for the market to signal its trends, the economy must also be cooking. Both the transposition and industrial index must both be moving in a similar direction to confirm this. When the performance of the two economic averages diverge, it can serve as a warning sign that change is in the air [see also Dow Futures: What Every Trader Needs to Know].

The Market Has Three Movements: When studying the two indexes, both Hamilton and Dow recognized that the averages had basically three patterns of movements – primary movements, secondary reactions and daily fluctuations. Primary movements are the major trend of the market and can last from a few months to several years. Typically, when investors say that stocks are in a bull or bear market, they are describing a primary movement. A secondary reaction or market swing is usually opposite from the primary direction of the market. This may last from 10 days to three months and generally retrace around 30% to 66% from the original movement. They are basically mini-rallies or sell-offs during a bull or bear. Finally, daily fluctuations are just that: swings up or down on a very short-term basis. Understanding the movements are key if investors want to profit from the market’s overall trend. Realizing that a secondary movement is just that and not a full on bear could lead to buying opportunities.

Three Stages of Bull & Bear Markets

Full Market Cycle Diagram

One of the other major parts to Dow Theory is understanding that markets—bull or bear—have three parts to them. Investors need to familiarize themselves with the various stages in order to understand how the market trends will play out. Primary market movements are categorized in three ways: an accumulation phase, a public participation phase and a distribution phase.

The accumulation phase is where investors and traders “in the know” begin buying stocks against the general opinion of the market. This is where the smart money is getting in or out of the markets. Prices for stocks don’t generally move that much and insiders are able to accumulate larger positions.

The public participation phase is when most retail investors begin to jump on board. The market’s trend has been well established and many investors get off the sidelines and begin buying with abandon. It is here that we see prices for stocks begin to really move. Talks of bubbles begin to make the airwaves and speculation becomes rampant.

The distribution phase is where the market tops and the smart money has already left or is starting to leave the building. By this point, most retail investors are just now joining the show and are buying at the top. Overpriced asset classes and sectors begin to pop and the market will drift downwards. This is also the start of the bear market cycle.

As for bear markets, the phases happen in reverse. The smart sells at the top, while less-sophisticated investors begin buying.

Putting Dow Theory To Work

Start of bullish trend

For investors, all of this information is no good unless you can put it to work in your portfolio. The real reason for all of this is to help identify a trend, so you can follow that trend to profits. Robert Rhea describes how a classic “buy signal” will occur during the end of a bear market. Rhea shows that after a primary downtrend in a Bear market is established, a secondary upwards bounce will occur. After this a retraction of at least 3% on one of the averages will occur. If that downward bounce does not go below the previous lows of the industrial and the transportation indexes, investors can begin buying the market.

start of bearish trend

Conversely, a bear market sell signal is determined in much the same way, but in reverse. New highs will be made, followed a slight dip before the market surges higher. However, if the market falls short of reaching the previous highs and then penetrates the recent lows on the next decline, it’s time to sell and move on.

The system isn’t perfect and doesn’t take into account various Black Swan style events, which can throw the entire model off in a matter of seconds. Another issue is the just when to determine how that secondary move up or down is really occurring. Traders have many interpretations on how that movement is defined. This can lead to false bear or bull market call for newbie investors.

The Bottom Line

Dow Theory in a nut shell is the oldest form of technical analysis and can be a great way for investors to spot the market’s overall tends. It takes some practice and basic knowledge, but once understood it can serve a portfolio well. Just keep in mind that it isn’t the end-all-be-all of market systems. The theory should be used in conjunction with other tools and indicators to make informed and profitable trades.

Aaron Levitt
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