DOW THEORY

Dow Theory is a theory about how to build wealth given the nature of movements of the US stock market. The theory originally derived from the editorials of Charles H. Dow (1851-1902), journalist, first editor of the Wall Street Journal and co-founder of Dow Jones and Company. It was refined after his death by William P. Hamilton, Charles Rhea and E. George Schaefer. Dow himself never used the term "Dow Theory".

Dow Theory asserts that bull markets are characterised by a primary trend that consists of three major upward thrusts (of the major indices) interrupted by two pull-backs i.e. periods of weakness. During the whole movement there can be expected to be rising tops (i.e. each advance reaching a higher high that the previous advance) and rising bottoms (each pullback or reaction reaching a higher low than the previous pullback).

Bear markets on the other hand are characterised by a primary trend that has declining tops (each lower than it's predecessor) and declining bottoms (each lower than it's predecessor)...with the whole bear movement depicted as usually consisting of a few intermediate (medium-term) declines and rallies.

Moreover, for the bull and bear primary trends to be confirmed Dow Theory says that the movements of the Industrial Average and the Railroad Average (today we would say the Industrial Average and the Transportation Average) need to confirm each other (both move in the same direction). More broadly the major components of the market need to be moving in tandem. The theory suggests that when the major indices are range-bound (e.g trading within a narrow channel with the top about 5% above the bottom), then the market is accumulating (prior to rising) or distributing (prior to falling). If the major indices then both move up or down from that narrow range, the market is said to have confirmed either an upward or a downward break.

References

• J. M. Hurst: The Profit Magic of Stock Transaction Timing. Englewood Cliffs, N.J.: Prentice-Hall, 1977. (Analysis of the empirical character of US stock market movements prior to 1973)
• John Murphy: Technical Analysis of Futures Markets. New York, N.Y.: New York Inst. of Finance, 1986.