The Dow theory is a stock market theory used as a basis for technical analysis.
The Dow theory was developed by William P. Hamilton, Robert Rhea, and E. George Schaefer from the work of Charles H. Dow, who was the founder and first editor of the Wall Street Journal and the co-founder of Dow Jones and Company, from which we still today have the Dow Jones Industrial Average.
The Dow theory forms the basis of technical analysis, in which investment decisions are made on the basis of trends in the stock chart as opposed to qualities of the underlying company or the stock price.
In short, the Dow theory says the market is trending upwards when both the Dow Jones Industrial Index and the Dow Jones Transportation Index exceed a previous, important high. Similarly, the market is trending downwards when both averages fall below previous lows. Technical investors seek to invest with the primary trend, not against it, i.e., buying during upward trends and selling during downward trends.
The Dow theory has six basic assumptions.
- The market discounts all news, that is, all of the news on a given company is already priced into the stock.
- The market has three main trends: the primary trend (the overriding trend of the market), the secondary trend (a smaller correction of the primary trend), and the minor trend (a correction of the secondary trend). Investors shouldn't confuse a secondary trend (a correction) with the primary trend.
- Every primary trend has three phases. In a bull market, the phases are the accumulation phase (when informed investors get involved after a bear market), the public participation phase, and the excess phase (when prices are run up). In a bear market, the phases are the distribution phase (when informed investors get out after a bull market), the public participation phase, and the panic phase. Accumulation phases and distribution phases are the most difficult to see, but also the most rewarding.
- The switch from a bear market primary trend to a bull market trend or vice versa cannot be confirmed until both indexes are in agreement.
- Volume is a secondary indicator to confirm the market trend. It should go up when prices are following the trend and go down when prices are going against the trend.
- Investors shouldn't assume the trend has changed (and therefore invest against the trend) until all of the indicators have confirmed the switch.
Critics of the Dow theory assert that by the time the theory provides clear buy or sell signals, investors have already missed most of the bargains (for buying) or highs (for selling). Warren Buffett famously abandoned technical analysis for value investing when he discovered turning the chart upside down didn't change the interpretation.
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