The Dow Theory
Co-founder of the famed Dow Jones and Company, Charles Dow was the first editor and founding father of the Wall Street Journal. The first principles of the Dow Theory were enunciated by Charles Dow. Later, William Hamilton built upon Dowâ€™s initial work and his contribution has been significant. Robert Rhea, George Schaefer, and Richard Russell were the other Dow Theorists whose writings are relevant even today.
The basic tenets of the Dow Theory as it is now known are:
1. The market exhibits three movements â€“ (i) the â€˜main movementâ€™ which is the major trend that may be either bullish or bearish, lasting between a year or less to several years; (ii) the "medium swing" or a market reaction that may last from ten days to three months with a 33% to 66% retracing of the primary price change and (iii) the "short swing" or minor variations lasting from a few from hours to a month or more. The three movements may be distinct or may overlap, as for instance, when daily minor movements occur within a bearish secondary reaction during a major bull run.
2. Market trends occur in three phases â€“ (i) there is a phase when investors are actively buying the stock contrary to market opinion, referred to as the accumulation phase. This is marked by little or no price change; (ii) the next phase where there is active trading by a larger section of the investing public is accompanied by rapid price increase, referred to as the public participation phase; and (iii) with speculation growing rife, savvy investors begin to offload their stock, resulting in a phase of distribution.
3. The stock market discounts all news - Stock price movements integrate and reflect the latest information and trends in the marketplace.
4. Stock market averages must confirm each other. That is to say that the movements of both the Industrial average and the Transportation average must confirm each other be considered together in order to draw a reliable inference. When the two averages are moving in the same direction, it would be a healthy sign. This tenet springs from the logistics perspective as things stood at that time in the U.S., and the Wall Street Journal continues to publish the daily performance of the Dow Jones Transportation Index with data for major railroads, shipping companies, and air freight carriers in the US.
5. Trends are confirmed by volume â€“ Dow placed emphasis on trade volumes for understanding price movements. Price movements accompanied by high volumes of trade in a particular stock were indicative of the true market valuation.
6. Trends exist until definitive signals prove that they have ended. It is important to understand the current trend, rather than to go by temporary reversals in market sentiment.
After his time, Dowâ€™s understudy William Hamilton continued his writings and made these significant additions to the initial work of his mentor:
â€¢ The Averages discount everything
â€¢ The primary trend cannot be manipulated
â€¢ Both the Industrials and the Transports must confirm each other in order for the signal to have authority
â€¢ The Theory is not infallible.
â€¢ Determining the trend by spotting "higher highs" or "lower lows"
Hamilton was able to achieve accurate predictions of the trends with surprising consistency, which was the reason for his huge following among the investing public. He is specially remembered for his prophetic prediction about the stock market crash of 1929 through the medium of an editorial he had authored on October 25, 1929, just days before the crash.
Cons: It is not easy to spot a reversal of trends or to gauge whether it is a temporary or major change. Although there exist technical analysis tools that attempt to pick the right signals, interpretation again varies with investor.
Pros: The basic tenets of the Dow Theory are still relevant in today's volatile and technology-driven markets.
Books: The Dow Theory by Robert Rhea
Video: Tenets of Dow Theory http://www.youtube.com/watch?v=biShqILFMl4
Dow Theory http://www.truveo.com/Dow-Theory/id/3540422 330