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Dow Theory

Through Dow's writings in The Wall Street Journal, several analysts derived what has become known as Dow Theory. Keep in mind that Dow Theory was never coined by Dow himself. He merely wrote his observations. Others decided that it was a valid theory. It has also gone through various interpretations. However, the basic points to Dow Theory are as follows:

There are three types of movements. A primary trend which takes place over the course of years. They can be either bull or bear trends. There are secondary movements which take place from weeks to months. These run contrary to the primary trend. And there are day to day fluctuations which can move in either direction (bull or bear). These are of slight importance other than the fact that they comprise the overall primary trend.

The second part of the Dow Theory is that the Industrial Average and the Railroad Average (at the time of Dow's writing there was only the Railroad Average. In 1969, Dow Jones & Company broadened this to include truckers and airlines so that today it would be confirmation by the Industrial Average and the Transportation Average) must corroborate each other's direction for there to be a reliable market direction signal.

When movements of several weeks or longer take place and are confined to a range of about 5%, a line is said to have been drawn. Accumulation or distribution is said to be taking place. When both averages break out above this line, accumulation is said to have taken place and prices should head higher. When both averages break down below this line, distribution is said to have taken place and prices should head lower. If one average crosses and the other doesn't, the move is said to be inconclusive.

An overbought market becomes dull on rallies and active on declines. An oversold market becomes dull on declines and active on rallies. Large volume shows up at the end of bull markets and light volume characterizes the end of a bear market.

Large active stocks will generally reflect the market averages. However, individual issues may deviate from the broad averages because of circumstances peculiar to them.

The logic behind the makeup of the specific averages is that both the industrials and the transports are independent of each other. Yet, for the industrials to get their product to market, they must use the transports. When the industrials are doing well, the transports will do well. However, when one sector is doing substantially better than the other, a divergence is taking place. This demonstrates that one sector is much stronger than the other; and if it continues, without the other sector catching up, a major reversal in the market will take place.

For the confirmation to take place, it isn't necessary for both averages to cross together. However, the one should then follow the other before the first average crossing pulls back across the line.

Dow Theory also specifies that closing prices should only be used. This is because closing prices reflect the price level at which informed investors are willing to carry positions overnight.

The first phase of a bull market is the accumulation phase. This is when prices are depressed and financial reports don't look good. However, farsighted investors use this period of depressed prices to take advantage and buy shares.

The second phase of the bull market is characterized by increased activity, rising prices, and better financial reports. This is the period where the large gains are made. Wall Street is the hot topic. And tales of large amounts of money being made are bandied about. At this point, the market becomes vulnerable to a reversal.

The first phase of a bear market is the distribution phase. This is where farsighted investors see the uninformed investors scrambling to buy shares. The farsighted investors begin to sell shares. Oversupply leads to weakening prices and profits are harder to come by.

The second phase of the bear market is characterized by near panic selling. Prices accelerate to the downside and more and more people begin to liquidate their holdings.

The third phase of the bear market is characterized by further weakening and erosion of prices. Lesser quality issues erase the gains of the previous bull market. The news is full of bad market news.