- Dow theory
Dow Theory on stock price movement is a form of technical analysis that includes some aspects of sector rotation. The theory was derived from 255 Wall Street Journal editorials written by Charles H. Dow (1851–1902), journalist, founder and first editor of the Wall Street Journal and co-founder of Dow Jones and Company. Following Dow's death, William Peter Hamilton, Robert Rhea and E. George Schaefer organized and collectively represented "Dow Theory," based on Dow's editorials. Dow himself never used the term "Dow Theory," nor presented it as a trading system.
The six basic tenets of Dow Theory as summarized by Hamilton, Rhea, and Schaefer are described below.
Six basic tenets of Dow Theory
- The market has three movements
- (1) The "main movement", primary movement or major trend may last from less than a year to several years. It can be bullish or bearish. (2) The "medium swing", secondary reaction or intermediate reaction may last from ten days to three months and generally retraces from 33% to 66% of the primary price change since the previous medium swing or start of the main movement. (3) The "short swing" or minor movement varies with opinion from hours to a month or more. The three movements may be simultaneous, for instance, a daily minor movement in a bearish secondary reaction in a bullish primary movement.
- Market trends have three phases
- Dow Theory asserts that major market trends are composed of three phases: an accumulation phase, a public participation phase, and a distribution phase. The accumulation phase (phase 1) is a period when investors "in the know" are actively buying (selling) stock against the general opinion of the market. During this phase, the stock price does not change much because these investors are in the minority demanding (absorbing) stock that the market at large is supplying (releasing). Eventually, the market catches on to these astute investors and a rapid price change occurs (phase 2). This occurs when trend followers and other technically oriented investors participate. This phase continues until rampant speculation occurs. At this point, the astute investors begin to distribute their holdings to the market (phase 3).
- The stock market discounts all news
- Stock prices quickly incorporate new information as soon as it becomes available. Once news is released, stock prices will change to reflect this new information. On this point, Dow Theory agrees with one of the premises of the efficient market hypothesis.
- Stock market averages must confirm each other
- In Dow's time, the US was a growing industrial power. The US had population centers but factories were scattered throughout the country. Factories had to ship their goods to market, usually by rail. Dow's first stock averages were an index of industrial (manufacturing) companies and rail companies. To Dow, a bull market in industrials could not occur unless the railway average rallied as well, usually first. According to this logic, if manufacturers' profits are rising, it follows that they are producing more. If they produce more, then they have to ship more goods to consumers. Hence, if an investor is looking for signs of health in manufacturers, he or she should look at the performance of the companies that ship the output of them to market, the railroads. The two averages should be moving in the same direction. When the performance of the averages diverge, it is a warning that change is in the air.
- Both Barron's Magazine and the Wall Street Journal still publish the daily performance of the Dow Jones Transportation Index in chart form. The index contains major railroads, shipping companies, and air freight carriers in the US.
- Trends are confirmed by volume
- Dow believed that volume confirmed price trends. When prices move on low volume, there could be many different explanations why. An overly aggressive seller could be present for example. But when price movements are accompanied by high volume, Dow believed this represented the "true" market view. If many participants are active in a particular security, and the price moves significantly in one direction, Dow maintained that this was the direction in which the market anticipated continued movement. To him, it was a signal that a trend is developing.
- Trends exist until definitive signals prove that they have ended
- Dow believed that trends existed despite "market noise". Markets might temporarily move in the direction opposite to the trend, but they will soon resume the prior move. The trend should be given the benefit of the doubt during these reversals. Determining whether a reversal is the start of a new trend or a temporary movement in the current trend is not easy. Dow Theorists often disagree in this determination. Technical analysis tools attempt to clarify this but they can be interpreted differently by different investors.
There is little academic support for the profitability of the Dow Theory. Alfred Cowles in a study in Econometrica in 1934 showed that trading based upon the editorial advice would have resulted in earning less than a buy-and-hold strategy using a well diversified portfolio. Cowles concluded that a buy-and-hold strategy produced 15.5% annualized returns from 1902-1929 while the Dow Theory strategy produced annualized returns of 12%. After numerous studies supported Cowles over the following years, many academics stopped studying Dow Theory believing Cowles's results were conclusive.
In recent years however, Cowles' conclusions have been revisited. William Goetzmann, Stephen Brown, and Alok Kumar believe that Cowles' study was incomplete  and that Dow Theory produces excess risk-adjusted returns. Specifically, the return of a buy-and-hold strategy was higher than that of a Dow Theory portfolio by 2%, but the riskiness and volatility of the Dow Theory portfolio was lower, so that the Dow Theory portfolio produced higher risk-adjusted returns according to their study. Nevertheless, adjusting returns for risk is controversial in the context of the Dow Theory. One key problem with any analysis of Dow Theory is that the editorials of Charles Dow did not contain explicitly defined investing "rules" so some assumptions and interpretations are necessary.
- Scott Peterson: The Wall Street Journal,Technically, A Challenge for Blue Chips, Vol. 250, No. 122, November 23, 2007.
- Goetzmann's Dow Page Includes a link to Dow's editorials and links to numerous articles describing support of Dow Theory.
- Alfred Cowle's Yale Page with selected publications
- Richard Russell's Dow Theory letters weekly newsletter and charts.
- John Hussman discusses Dow Theory
- Record of Dow Theory Signals
- Dow Theory blog and definition
Classic Books by Dow Theorists
- Dow Theory for the 21st Century, by Jack Schannep 
- Dow Theory Today, by Richard Russell 
- The Dow Theory, by Robert Rhea 
- The Stock Market Barometer, by William Hamilton 
- The ABC of Stock Speculation, by S.A. Nelson 
Concepts Charts PatternsCandlestickSimpleComplex IndicatorsVolumeOther Stock market Types of stocks Participants Exchanges Stock valuation Financial ratios Trading theories
and strategiesAlgorithmic trading · Buy and hold · Contrarian investing · Day trading · Efficient-market hypothesis · Fundamental analysis · Market timing · Modern portfolio theory · Momentum investing · Mosaic theory · Pairs trade · Post-modern portfolio theory · Random walk hypothesis · Style investing · Swing trading · Technical analysis · Trend following
Related termsBlock trade · Cross listing · Dark liquidity · Dividend · Dual-listed company · DuPont Model · Flight-to-quality · Haircut · IPO · Margin · Market anomaly · Market capitalization · Market depth · Market manipulation · Market trend · Mean reversion · Momentum · Open outcry · Public float · Rally · Reverse stock split · Share capital · Short selling · Slippage · Speculation · Stock dilution · Stock split · Trade · Uptick rule · Volatility · Voting interest · Stock market index
- The market has three movements
Wikimedia Foundation. 2010.
Look at other dictionaries:
Dow Theory — is a heterodox theory on stock price movements that is used as the basis for technical analysis. The theory was derived from 255 Wall Street Journal editorials written by Charles H. Dow (1851 ndash;1902), journalist, founder and first editor of… … Wikipedia
Dow Theory — Used in the context of general equities. Technical theory that a major trend in the stock market must be confirmed by simultaneous movement of the Dow Jones Industrial Average and the Dow Jones Transportation Average to new highs or lows.… … Financial and business terms
dow theory — ˈdau̇ noun also dow s theory ˈdau̇z Usage: usually capitalized D Etymology: after Charles H. Dow died 1902 more at dow jones average : a system of stock market forecasting based on the observed swings of the market itself * * * Dow theory, U.S … Useful english dictionary
Dow Theory — A theory which says the market is in an upward trend if one of its averages (industrial or transportation) advances above a previous important high, it is accompanied or followed by a similar advance in the other. The theory also says that when… … Investment dictionary
Dow Jones Transportation Average — Stammdaten Staat Vereinigte Staaten Börse New York Stock Exchange ISIN XC0009694214 … Deutsch Wikipedia
Dow Jones Transportation Average — The Dow Jones Transportation Average (DJTA, also called the Dow Jones Transports ) is a U.S. stock market index from Dow Jones Indexes of the transportation sector, and is the most widely recognized gauge of the American transportation sector. It … Wikipedia
Dow, Charles Henry — ▪ American journalist born Nov. 6, 1851, Sterling, Conn., U.S. died Dec. 4, 1902, Brooklyn, N.Y. American journalist who cofounded Dow Jones & Company, a financial news service, and The Wall Street Journal. His original contributions include the … Universalium
dow's theory — noun see dow theory … Useful english dictionary
Dow 36,000 — Dow 36,000: The New Strategy for Profiting From the Coming Rise in the Stock Market is a book by James K. Glassman and Kevin A. Hassett. It was published in 1999, shortly before the dot com bubble burst, and predicted that the Dow Jones… … Wikipedia
Dow Jones Industrial Average — Recent logarithmic graph of the DJIA from Jan 2000 through Jul 2011 … Wikipedia