Dow Theory

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Dow Theory is a heterodox theory on stock price movements that is used as the basis for technical analysis. The theory was derived from 255 Wall Street Journal editorials written by Charles H. Dow (1851–1902), journalist, founder and first editor of the Wall Street Journal and co-founder of Dow Jones and Company. Following Dow's death, William P. Hamilton, Robert Rhea and E. George Schaefer organized and collectively represented "Dow Theory," based on Dow's editorials. Dow himself never used the term "Dow Theory," nor presented it as a trading system.

The six basic tenets of Dow Theory as summarized by Hamilton, Rhea, and Schaefer are described below.
Contents
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* 1 Six basic tenets of Dow Theory
* 2 Analysis
* 3 References
* 4 Further reading
* 5 External links

Six basic tenets of Dow Theory

1. The market has three movements

(1) The "main movement", primary movement or major trend may last from less than a year to several years. It can be bullish or bearish. (2) The "medium swing", secondary reaction or intermediate reaction may last from ten days to three months and generally retraces from 33% to 66% of the primary price change since the previous medium swing or start of the main movement. (3) The "short swing" or minor movement varies with opinion from hours to a month or more. The three movements may be simultaneous, for instance, a daily minor movement in a bearish secondary reaction in a bullish primary movement.

2. Trends have three phases

Dow Theory asserts that major market trends are composed of three phases: an accumulation phase, a public participation phase, and a distribution phase. The accumulation phase (phase 1) is a period when investors "in the know" are actively buying (selling) stock against the general opinion of the market. During this phase, the stock price does not change much because these investors are in the minority absorbing (releasing) stock that the market at large is supplying (demanding). Eventually, the market catches on to these astute investors and a rapid price change occurs (phase 2). This occurs when trend followers and other technically oriented investors participate. This phase continues until rampant speculation occurs. At this point, the astute investors begin to distribute their holdings to the market (phase 3).

3. The stock market discounts all news

Stock prices quickly incorporate new information as soon as it becomes available. Once news is released, stock prices will change to reflect this new information. On this point, Dow Theory agrees with one of the premises of the efficient market hypothesis.

4. Stock market averages must confirm each other

In Dow's time, the US was a growing industrial power. The US had population centers but factories were scattered throughout the country. Factories had to ship their goods to market, usually by rail. Dow's first stock averages were an index of industrial (manufacturing) companies and rail companies. To Dow, a bull market in industrials could not occur unless the railway average rallied as well, usually first. According to this logic, if manufacturers' profits are rising, it follows that they are producing more. If they produce more, then they have to ship more goods to consumers. Hence, if an investor is looking for signs of health in manufacturers, he or she should look at the performance of the companies that ship the output of them to market, the railroads. The two averages should be moving in the same direction. When the performance of the averages diverge, it is a warning that change is in the air.
Both Barron's Magazine and the Wall Street Journal still publish the daily performance of the Dow Jones Transportation Index in chart form. The index contains major railroads, shipping companies, and air freight carriers in the US.

5. Trends are confirmed by volume

Dow believed that volume confirmed price trends. When prices move on low volume, there could be many different explanations why. An overly aggressive seller could be present for example. But when price movements are accompanied by high volume, Dow believed this represented the "true" market view. If many participants are active in a particular security, and the price moves significantly in one direction, Dow maintained that this was the direction in which the market anticipated continued movement. To him, it was a signal that a trend is developing.

6. Trends exist until definitive signals prove that they have ended

Dow believed that trends existed despite "market noise". Markets might temporarily move in the direction opposite the trend, but they will soon resume the prior move. The trend should be given the benefit of the doubt during these reversals. Determining whether a reversal is the start of a new trend or a temporary movement in the current trend is not easy. Dow Theorists often disagree in this determination. Technical analysis tools attempt to clarify this but they can be interpreted differently by different investors.

Analysis

There is little academic support for the profitability of the Dow Theory. Alfred Cowles in a study in Econometrica in 1934 showed that trading based upon the editorial advice would have resulted in earning less than a buy-and-hold strategy using a well diversified portfolio. Cowles concluded that a buy-and-hold strategy produced 15.5% annualized returns from 1902-1929 while the Dow Theory strategy produced annualized returns of 12%. After numerous studies supported Cowles over the following years, many academics stopped studying Dow Theory believing Cowles's results were conclusive.

In recent years however, Cowles' conclusions have been revisited. William Goetzmann, Stephen Brown, and Alok Kumar believe that Cowles' study was incomplete [1] and that Dow Theory produces excess risk-adjusted returns.[1] Specifically, the return of a buy-and-hold strategy was higher than that of a Dow Theory portfolio by 2%, but the riskiness and volatility of the Dow Theory portfolio was lower, so that the Dow Theory portfolio produced higher risk-adjusted returns according to their study. Nevertheless, adjusting returns for risk is controversial in the context of the Dow Theory. One key problem with any analysis of Dow Theory is that the editorials of Charles Dow did not contain explicitly defined investing "rules" so some assumptions and interpretations are necessary.

Many technical analysts consider Dow Theory's definition of a trend and its insistence on studying price action as the main premises of modern technical analysis.

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Dow Theorists disagree
Commentary: Stock market as confusing to them as everyone else
By Mark Hulbert, MarketWatch
Last update: 11:28 p.m. EDT July 3, 2008


ANNANDALE, Va. (MarketWatch) -- When the Dow ended the trading session this past Wednesday 20.8% below its close of Oct. 10, it did more than officially confirm that we're in a bear market.

Depending on which Dow Theorist one consults, Wednesday's action also set up the preconditions for a Dow Theory sell signal.

The Dow Theory, of course, is the oldest stock market timing system in widespread use today. Its author was William Peter Hamilton, who introduced it in a series of editorials in The Wall Street Journal over the first three decades of the past century. Crucially, from the point of view of latter-day disputes over its current meaning, Hamilton never codified his theory into a precise set of rules that could be mechanically applied.

In general, though, the outlines of the Dow Theory are straightforward. Hamilton argued that it is bullish if both the Dow Jones Industrials Average jointly reach significant new highs. Similarly, the market is likely to continue falling if both Averages jointly reach significant new lows. (Of course, it wasn't known as the Transportation average back then; it was the Dow Jones Railroad Average).

Potential turning points are signaled when only one of the two Averages reaches a new high or a new low--"non confirmations" in Dow Theory parlance.

Unfortunately, these general outlines contain an incredible amount of ambiguity. Just take the current market forecasts of the three Dow Theory newsletters that are tracked by the Hulbert Financial Digest.

Consider first Jack Schannep, editor of TheDowTheory.com. Schannep differs from the other two Dow Theorists I track by allowing buy and sell signals to be triggered by smaller and shorter-term moves in the two Dow averages. On that basis, he argues that the Dow Theory went on a sell signal after the close on June 22 - well before the stock market's decline of this past week.

Consider next Richard Moroney, editor of Dow Theory Forecasts, whose most recent Dow Theory signal was a bullish signal triggered this Spring. In his latest issue, written after Wednesday's close, Moroney wrote that there are three different ways in which the Dow Theory could go at this point:

*Confirmed new highs. If the Industrials rebound to close above 13,058.20 and the Transports close above 5,492.95, the bullish primary trend would be reconfirmed.

*A breakdown below the March low in the Transports. With a close below 4,398.97 in the Transports, both the Industrials and Transports would be trading below prior significant lows -- and the validity of April's bull-market signal would have to be questioned.

*Failed attempts at new highs. If the market rebounds without achieving new highs in both averages, then both averages move below the lows reached in the current correction, the Dow Theory would shift to the bearish camp.

Though Moroney doesn't come out and say so in his latest issue, in prior issues he has said that, from a Dow Theory point of view, the primary trend is presumed to remain in force until a contrary signal is triggered. On that basis, therefore, Moroney must be considered bullish.

Finally, consider Richard Russell, editor of Dow Theory Letters. In many crucial respects, he agrees with Moroney's delineation of the key levels to watch in the two major Dow averages in coming weeks and months. However, in recent postings to his website, he has thrown a major kink into the works by suggesting that, far from confirming that a major bear market is in progress and presaging further market weakness, a close in the Transportation Average below its January low might instead signal that the market's decline is about over.

Here's Russell's rationale: "Sometimes a belated confirmation can signal that we're close to the end of a move. That's what happened during the 1932-37 bull market. In that instance, the Rails hit a high in June 1933 and then sold off while the Dow continued higher. Three years went by while the Rails stubbornly refused to confirm the rising Dow. Robert Rhea (the great Dow Theorist) wrote that maybe when the Rails finally do confirm the Industrials, the bull market will be near its end. In July 1936 the Rails finally confirmed the advancing Dow. But the belated Rail confirmation did indeed occur near the end of the long advance. The bull market pushed a bit higher into March 1937 and then fell apart. Over the next year the Dow lost roughly half its value."

The bottom line? This stock market is as confusing from a Dow Theory point of view as it is from lots of other perspectives as well.