Dow Theory

Dr Saif Siddiqui
 Introduction

 More than 100 years old, Dow theory remains the

foundation of 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.
 Introduction
 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,
 Introduction
Some important contributions to Dow theory
 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)
 Richard Russell's "The Dow Theory Today"
(1961).
 Introduction
 Dow believed that
 the stock market is a reliable measure of overall
business conditions
 By analyzing the overall market, one could
accurately gauge those conditions
 and identify the direction of major market trends
and the likely direction of individual stocks.
 Introduction
 Dow first used his theory to create
 The Dow Jones Industrial Index and
 The Dow Jones Rail Index
• now Transportation Index
 which were originally compiled by Dow for The
Wall Street Journal.
 Introduction
 He felt that:
 These indexes were an accurate reflection of the
business conditions within the economy
 Because they covered two major economic
segments: industrial and rail (transportation)
Six basic tenets of Dow theory
 The Market Discounts Everything
 The Three-Trend Market
 The Three Phases of Primary Trends
 Market Indexes Must Confirm Each Other
 Volume Must Confirm The Trend
 Trend Remains in effect until Clear Reversal
occurs
1.The Market Discounts Everything
 The first basic premise of Dow theory suggests
 All information - past, current and even
future
 is discounted into the markets and
 reflected in the prices of stocks and indexes.
 The Market Discounts Everything
 That information includes everything
 emotions of investors , inflation
 interest-rate data
 pending earnings announcements
 the only information excluded is that which is
unknowable, such as a massive earthquake.
 The Market Discounts Everything
 Like mainstream technical analysis, Dow theory is
mainly focused on price.
 The two differ in that
 Dow theory is concerned with the movements of
the broad markets
• rather than specific securities.
 2.The Three-Trend Market

 The market tends to move in a general direction,

or trend,
 it doesn't do so in a straight line.

 The market will rally up to a high (peak) and then

sell off to a low (trough),
 but will generally move in one direction.
The Three-Trend Market
 An upward trend is broken up into several rallies,
where each rally has a high and a low
 For a market to be considered in an uptrend,
 each peak in the rally must reach a higher
level than the previous rally's peak, and
 each low in the rally must be higher than the
previous rally's low.
An Upward trend
 A downward trend
 A downward trend is broken up into several sell-
offs, in which each sell-off also has a high and a
low.
 To be considered a downtrend in Dow terms,
 each new low in the sell-off must be lower than
the previous sell-off's low and
 the peak in the sell-off must be lower then the
peak in the previous sell-off.
Downward trend
 Three trends
 Primary
 the largest trend lasting for more than a year,
 Secondary
 an intermediate trend that lasts three weeks to three months and
 Minor
 lasts less than three weeks
Primary Trend
 In Dow theory, the primary trend is the major
trend of the market,
 The primary trend will also impact the secondary
and minor trends within the market.
Primary Trend
Secondary or Intermediate Trend
 A secondary trend moves
 in the opposite direction of the primary trend, or
 as a correction to the primary trend.
 An upward primary trend will be composed of
secondary downward trends.
 In a primary downward trend the secondary trend
will be an upward move, or a rally.
Secondary or Intermediate Trend
DJIA
Coca Cola at NYSE
Minor Trend
 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.
Minor Trend
3. Three Phases of Primary Trends
 Primary Upward Trend (Bull Market)
 The Accumulation Phase
 Public Participation Phase
 The Excess Phase
 Primary Downward Trend (Bear Market)
 The Distribution Phase
 Public Participation Phase
 The Panic Phase
Primary Upward Trend
The Accumulation Phase
 The first stage of a bull market is referred to as
the accumulation phase,
 which is the start of the upward trend.
 The accumulation phase typically comes at the
end of a downtrend,
 when everything is seemingly at its worst
The Accumulation Phase
Primary Upward Trend
Public Participation Phase
 Informed investors entered the market during the
accumulation phase,
 Negative sentiment starts to dissipate as business
conditions improve
 As the good news starts to permeate the market,
 more and more investors move back in

 sending prices higher.

Public Participation Phase
 Primary Upward Trend
The Excess Phase
 The smart money starts to scale back its positions,
 selling them off to those now entering the market

 "irrational exuberance".
 The perception is that everything is running great and
that only good things lie ahead.
 This is the time when the last of the buyers start to enter the
market
 after large gains have been achieved.,
 they are buying near the top.
The Excess Phase
 Primary Downward Trend
The Distribution Phase
 The period in which informed buyers sell (distribute)

their positions.
 The informed buyers are now selling into an overbought

market
 It is also the phase in which there is continued buying

by the last of the investors in the market,

 especially those who missed the big move but are

hoping for a similar one in the near future.

 Primary Downward Trend
Public Participation Phase
 The business conditions in the market gets worse
 the sentiment becomes more negative as time

goes on.
 The market continues to discount the worsening

conditions as selling increases and buying dries up.

 Primary Downward Trend
The Panic Phase
 The last phase of the primary downward market tends

to be filled with market panic and

 can lead to very large sell-offs in a very short

period of time.
 In the panic phase, the market is filled up with

negative sentiment,
 including weak outlooks on companies, the

economy and the overall market.

4.Market Indexes Must Confirm Each Other

 A major reversal from a bull to a bear market (or vice

versa) cannot be signaled unless both indexes
(traditionally the Dow Industrial and Rail Averages)
are in agreement.
 If one index is confirming a new primary uptrend but
another index remains in a primary downward trend,
 it is difficult to assume that a new trend has
begun.
5. Volume Must Confirm The Trend
 In an uptrend, volume should increase when the
price rises and fall when the price falls.
 if volume runs counter to the trend, it is a sign

of weakness in the existing trend.

 If the market is in an uptrend but volume is
weak ,it is a signal that buying is starting to
dissipate.
 6. Trend Remains in effect until Clear
Reversal occurs

 Traders wait for a clear picture of a trend reversal

 not to confuse a true reversal in the primary

trend with a secondary trend or brief correction.

 Unless you can safely conclude, based on the
weight of evidence, that the trend has changed,
you will be trading against the trend.
 Current Relevance
 Followers can miss out on large gains due to the
conservative nature of a trend-reversal signal.
 Over time, the economy - and the indexes originally
used by Dow - has changed.
 The industrial and transportation sectors of the
economy are not the only dominant parts.