If you use technical analysis, you have Charles Dow—cofounder of the Wall Street Journal and Dow Jones Industrial Average—to thank. He created the principles of “Dow theory,” a foundation of modern technical analysis, which is still valid today.
Why is Dow theory important? Can it help you trade?
All technical analysis derives from Charles Dow’s findings that markets move in trends, and that these trends are discernable. Dow, who died in 1902, used the analogy of the ebb and flow of tides to describe how the market acts. He believed that stocks move in trends, similar to how water crashes onto the beach, leaving patterns in the sand to show where high and low tides may occur. Quite obviously, if you can identify the direction of market trends, you may be able to better position your portfolio.
Dow theory primer
When Dow was researching the market in the late 1800s, there were far fewer stocks, and indexes would not become as commonly used as they are now for quite some time. Dow, who was well ahead of his time in terms of how he looked at the overall market, created two indexes (or averages, as they are referred to in Dow theory): Industrials and Transports. These averages served as the basis for his analysis of primary and secondary trends.
Here are the key tenets of Dow theory:
- The primary trend is inviolate.
- The averages discount everything.
- The theory is not infallible.
“The primary trend is inviolate” refers to the idea that the general direction of the market is not determined by the actions of big participants, but rather by the natural movements of the market as a whole.
The most relevant aspect of Dow theory is his assertion that “the averages discount everything,” with the market moving in waves (see sidebar). Dow thought that market moves could be forecasted because the movement of the averages (or indexes, as we now more commonly refer to them) included expectations for the future. This idea, that markets are forward looking and we can observe expected behavior in price action, is the crux of all technical analysis.
Dow theory in action
If there is one critical thing to know about Dow theory, it is this: the averages must confirm one another. For example, suppose during a bull rally that the Transports made a new relative high, but the Industrials did not. The fact that the averages did not confirm one another (that is, both did not make new relative highs) may indicate a reversal. Consequently, both averages might fall below a significant intermediate support level (see chart below).
In addition to Dow’s belief that the movements of the averages must confirm each other, he thought that volume must confirm the trend as well. He assumed an existing trend to be in place until clear signals, confirmed by volume, indicated that it has reversed.
Of course, Dow theory is one more way that you may try to assess the market. Many technical analysts use several tools and methods, including fundamental analysis, to help spot changes in trends. Dow theory, created by the father of technical analysis, can be another tool at your disposal.
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