DOW THEORY

Dow Jones???
 DOW THEORY
✔ Any attempt to trace the origins of technical analysis would inevitably lead
to Dow theory. While more than 100 years old, Dow theory remains the
foundation of much of what we know today as technical analysis.

✔ Dow theory was formulated from a series of Wall Street Journal editorials
authored by Charles H. Dow from 1900 until the time of his death in 1902.

✔ These editorials reflected Dow's beliefs on how the stock market behaved
and how the market could be used to measure the health of the business
environment.

✔ Due to his death, Dow never published his complete theory on the markets,
but several followers and associates have published works that have
expanded on the editorials. Some of the most important contributions to
Dow theory were William P. Hamilton's "The Stock Market Barometer"
(1922), Robert Rhea's "The Dow Theory" (1932), E. George Schaefer's "How
I Helped More Than 10,000 Investors To Profit In Stocks" (1960) and Richard
Russell's "The Dow Theory Today" (1961).
 DOW THEORY
✔ The Dow theory is the oldest, and by far the most publicized, method of
identifying major trends in the stock market.

✔ The basic principles of the Dow theory are used in other branches of
technical analysis.

✔ The goal of the theory is to determine changes in the primary, or major,

movement of the market. Once a trend has been established, it is
assumed to exist until a reversal is proved.

✔ Dow theory is concerned with the direction of a trend and has no

forecasting value as to the trend’s ultimate duration or size.

✔ It should be recognized that the theory does not always keep pace with
events; it occasionally leaves the investor in doubt, and it is by no means
infallible, since losses, as with any other technical approach, are
occasionally incurred.
 DOW THEORY
✔ The theory assumes that the majority of stocks follow
the underlying trend of the market most of the time.

✔ In order to measure “the market,” Dow constructed

two indexes, which are now called the Dow Jones
Industrial Average, which was originally a
combination of 12 (but now includes 30) bluechip
stocks, and the Dow Jones Rail Average, comprising
12 railroad stocks.

✔ Since the Rail Average was intended as a proxy for

transportation stocks, the evolution of aviation and
other forms of transportation has necessitated
modifying the old Rail Average in order to incorporate
additions to this industry.

✔ Consequently, the name of this index has been

changed to Transportation Average. https://www.aaii.com/journal/article/charles-dows-theory-still-valid-fo
r-the-21st-century
Big Picture Technical
Indicators
• The Dow Theory https://www.investopedia.com/terms/d/dowtheory.asp

• Dow theory is a technical approach based on https://youtu.be/fU2z0X58CHc

the idea that the stock market's behavior can
be best described by the long-term price
trend of the Dow Jones Industrial Index and
the Dow Jones Transportation Index.

• If the values of both indexes are rising, We

say that we are in a bull market.

• If the Dow Jones Industrial Average declines

and the Transportation index follows suit, we
say that the markets have entered into a
bearish period.

• An after-the-fact measure with no predictive

power.
Interpreting the Theory:
The six basic tenets of the theory
1. The Averages Discount Everything
✔ The first basic premise of Dow theory suggests that all
information - past, current and even future - is
discounted into the markets and reflected in the
prices of stocks and indexes.
✔ Changes in the daily closing prices reflect the
aggregate judgment and emotions of all stock market
participants, both current and potential.
✔ It is, therefore, assumed that this process discounts
everything known and predictable that can affect the
demand/supply relationship of stocks.
✔ That information includes everything from the
emotions of investors to inflation and interest-rate
data, along with pending earnings announcements to
be made by companies after the close. Based on this
tenet, the only information excluded is that which is
unknowable, such as a massive earthquake. But even
then the risks of such an event are priced into the
market.
✔ Like mainstream technical analysis, Dow theory is
mainly focused on price. However, the two differ in
that Dow theory is concerned with the movements of
the broad markets, rather than specific securities.
 2. The Market Has Three Movements
✔ There are simultaneously three movements
in the stock market.

✔ Dow theory identifies three trends within

the market: primary, secondary and minor.

✔ A primary trend is the largest trend lasting

for more than a year, while

✔ a secondary trend is an intermediate trend

that lasts three weeks to three months and
is often associated with a movement
against the primary trend.

✔ Finally, the minor trend often lasts less than

three weeks and is associated with the
movements in the intermediate trend.
 2. The Market Has Three Movements

✔ An upward trend is broken up into several rallies, where ✔ A downward trend is broken up into several sell-offs, in which
each rally has a high and a low. each sell-off also has a high and a low.
✔ For a market to be considered in an uptrend, each peak in ✔ To be considered a downtrend in Dow terms, each new low in
the rally must reach a higher level than the previous rally's the sell-off must be lower than the previous sell-off's low and
peak, and each low in the rally must be higher than the the peak in the sell-off must be lower then the peak in the
previous rally's low. previous sell-off.
✔ Now that we understand how Dow theory defines a trend, we can look at the finer points of trend analysis
 2. The Market Has Three Movements
(i) Primary Movement, (2) Secondary Reaction, (iii) Minor Movement
(i) Primary Movement
✔ The most important is the primary or major trend, more
generally known as a bull (rising) or bear (falling) market.

✔ Such movements last from less than one year to several years.

✔ A primary bull market is a broad upward movement, normally

averaging at least 18 months, which is interrupted by
secondary reactions.

✔ The Bull market stages:

▪ 1st: The bull market begins when the averages have
discounted the worst possible news and confidence
about the future begins to revive.
▪ 2nd: The second stage of the bull market is the response
of equities to known improvements in business
conditions, while
▪ 3rd: the third and final phase evolves from
overconfidence and speculation when stocks are
advanced on projections that usually prove to be
unfounded.

Regardless of trend length, the primary trend remains in effect

until there is a confirmed reversal.
 2. The Market Has Three Movements
(i) Primary Movement, (2) Secondary Reaction, (iii) Minor Movement

(i) Primary Movement

A primary bear market is a long decline
interrupted by important rallies. It begins as the
hopes on which the stocks were first purchased
are abandoned. The second phase evolves as
the levels of business activity and profits
decline. In the third stage, the bear market
reaches a climax when stocks are liquidated,
regardless of their underlying value (because of
the de pressed state of the news or because of
forced liquidation caused, for example, by
margin calls). Regardless of trend length, the
primary trend remains in effect until there is a
confirmed reversal.

For example, if in an uptrend the price closes

below the low of a previously established
trough, it could be a sign that the market is
headed lower, and not higher.
 2. The Market Has Three Movements
(i) Primary Movement, (2) Secondary Reaction, (iii) Minor Movement
(ii) Secondary Reaction
✔ In Dow theory, a primary trend is the main
direction in which the market is moving.
Conversely, a secondary trend moves in the
opposite direction of the primary trend, or as a
correction to the primary trend.

✔ For example, an upward primary trend will be

composed of secondary downward trends. This is
the movement from a consecutively higher high to
a consecutively lower high. In a primary
downward trend the secondary trend will be an
upward move, or a rally. This is the movement
from a consecutively lower low to a consecutively
higher low.

✔ Figure: Notice how the short-term highs (shown

by the horizontal lines) fail to create successively
higher peaks, suggesting that a short-term
downtrend is present. Since the retracement does
not fall below the February low, traders would use
this to confirm the validity of the correction within
a primary uptrend.
 2. The Market Has Three Movements
(i) Primary Movement, (2) Secondary Reaction, (iii) Minor Movement
(ii) Secondary Reactions
✔ A secondary or intermediate reaction is defined
as “an important decline in a bull market or
advance in a bear market, usually lasting from
three weeks to as many months, during which
interval, the movement generally retraces from
33 to 66 percent of the primary price change
since the termination of the last preceding
secondary reaction.

✔ This relationship is shown in Figure 3.1.

Occasionally, a secondary reaction can retrace
the whole of the previous primary movement,
but normally, the move falls in the onehalf to
two thirds area, often at the 50 percent mark.

✔ As discussed in greater detail later, the correct

differentiation between the first leg of a new
primary trend and a secondary movement
within the existing trend provides Dow theorists
with their most difficult problem.
 2. The Market Has Three Movements
(i) Primary Movement, (2) Secondary Reaction, (iii) Minor Movement

(iii) Minor Movements

✔ Defined as a market movement lasting less than
three weeks. The minor trend is generally the
corrective moves within a secondary move, or
those moves that go against the direction of the
secondary trend.

✔ The minor movement lasts from a week or two up

to as long as six weeks. It is important only in that
it forms part of the primary or secondary moves;
it has no forecasting value for longer term
investors. This is especially important since short
term movements can be manipulated to some
extent, unlike the secondary or primary trends.

✔ Due to its short-term nature and the longer-term

focus of Dow theory, the minor trend is not of
major concern to Dow theory followers.
 3. Lines Indicate Movement
✔ Rhea defined a line as “a price movement two to
three weeks or longer, during which period, the price
variation of both averages moves within a range of
approximately 5 percent (of their mean average).

✔ I see no reason why the 5 percent rule cannot be

exceeded. After all, it really represents a digestion of
gains or losses or a pause in the trend. Such a
movement indicates either accumulation stock
moving into strong and knowledgeable hands and
therefore bullish or distribution [stock moving into
weak hands and therefore bearish].”

✔ An advance above the limits of the “line” indicates

accumulation and predicts higher prices, and vice
versa. When a line occurs in the middle of a primary
advance, it is really forming a horizontal secondary
movement and should be treated as such. My own
view is that the formation of a legitimate line should
probably take longer than 2 to 3 weeks. After all, a
line is really a substitute for an intermediate price
trend and 2 to 3 weeks is the time for a short term or
minor price movement.
 4. Price/Volume Relationships Provide Background
✔ The main signals for buying and selling are based on the price
movements of the indexes. Volume is also used as a secondary
indicator to help confirm what the price movement is suggesting.

✔ Volume should increase when the price moves in the direction of the
trend and decrease when the price moves in the opposite direction
of the trend.
For example, in an uptrend, volume should increase when the
price rises and fall when the price falls. The reason for this is
that the uptrend shows strength when volume increases
because traders are more willing to buy an asset in the belief
that the upward momentum will continue.
Low volume during the corrective periods signals that most
traders are not willing to close their positions because they
believe the momentum of the primary trend will continue.

✔ Conversely, if volume runs counter to the trend, it is a sign of

weakness in the existing trend.
For example, if the market is in an uptrend but volume is weak
on the up move, it is a signal that buying is starting to
dissipate.
✔ According to Dow theory, once a trend has been confirmed by volume, the
If buyers start to leave the market or turn into sellers, there is
majority of money in the market should be moving with the trend and not
little chance that the market will continue its upward trend.
against it.
The same is true for increased volume on down days, which is
an indication that more and more participants are becoming
✔ Volume and the technical indicators that are derived from it are undoubtedly
sellers in the market.
some of the most powerful tools at the disposal of proponents of Dow Theory.
4. Price/Volume Relationships Provide Background
PETRONAS GAS BERHAD [S] (6033)
 5. Price Action Determines the Trend
✔ Bullish indications are given when successive rallies penetrate
peaks while the trough of an intervening decline is above the
preceding trough. Conversely, bearish indications come from a
series of declining peaks and troughs.

✔ Figure 3.2 shows a theoretical bull trend interrupted by a

secondary reaction. In example a, the index makes a series of
three peaks and troughs, each higher than its respective
predecessor.

✔ The index rallies following the third decline, but is unable to

surpass its third peak. The next decline takes the average below
its low point, confirming a bear market as it does so, at point X.

✔ In example b, following the third peak in the bull market, a bear

market is indicated as the average falls below the previous
secondary trough. In this instance the preceding secondary was
part of a bull market, not the first trough in a bear market, as
shown in example a.

✔ Many Dow theorists do not consider penetration at point X in

example b to be a sufficient indication of a bear market. They
prefer to take a more conservative position by waiting for a rally
and subsequent penetration of that previous trough marked as
point Y in example b.
 6. The Averages Must Confirm
✔ One of the most important principles of
Dow theory is that the movement of the
Industrial Average and the Transportation
Average should always be considered
together; i.e., the two averages must
confirm each other.

✔ The need for confirming action by both

averages would seem fundamentally
logical, for if the market is truly a
barometer of future business conditions,
investors should be bidding up the prices,
both of companies that produce goods and
of companies that transport them, in an
expanding economy.

✔ It is not possible to have a healthy

economy in which goods are being
manufactured but not sold (i.e., shipped to
market). This principle of confirmation is
shown in Figure 3.4