Dow Theory Explained

Using the Principle of Trend Confirmation between Two Stock Indices

Feb 20, 2009

Dow theory was created as a leading indicator of the business cycle. It should be used to confirm or deny a market turn, and establish the direction of the primary trend.

Dow theory forms the basis of technical analysis. It is the work of Charles Henry Dow (1851–1902), a founder and former editor of The Wall Street Journal, the person believed to have invented stock market averages.

Dow also devised the original method for identifying trends in the stock market, which was later refined by William Hamilton and Robert Rhea.

Dow likened the movement of markets with the behavior of the sea. The primary trend in the market corresponds to the direction of the tide, the secondary reactions and rallies are the waves, and the movements of lesser degree are the ripples on the waves.

Dow Theory - A Warning of Trend Change

A fundamental tenet of Dow Theory is that a bull market is formed of a series of rising peaks and rising troughs, whereas a bear market is formed of falling peaks and falling troughs. Dow theory works with a pair of indices. Therefore, a bull market is not signalled until bothprimary and secondary indices conform to the bull market pattern, and a bear market is not signalled until bothindices conform to the bear pattern (see Figures 1 and 2).

In all cases, it is reasonable to expect that if a trend is developing, both primary and secondary indices should perform together. If not, a divergence between the two suggests that a reversal might be imminent. That is, non-confirmation provides a useful warning of an imminent reversal.

Original Dow Theory Indices

The primary index must be used in complement with the secondary index. Moreover, the secondary index must consist of stocks that are entirely differentfrom those that are included in the primary index.

The original Dow Theory was devised over a hundred years ago. Indices used were the Industrials and Rails and these needed to confirm each other in order for the signal of change of trend to have authority. Today, the modern version of the Rails index is the Transports. To see how this current signal performs, there is a record available illustrating this signal of trend change.

Dow Theory Useful in Different Markets

According to banker and trader, Tony Plummer, traders may use the Dow Theory concept extended to other pairs of indices in different markets. For example:

How Good is Dow Theory?

Dow Theory has been criticized because the signals it provides are very late. However, the signals are usually very accurate. First, an apparent reversal in only one index is often aborted if the other does not confirm it, and second, a confirmed buy or sell signal is invariably correct.

The copyright of the article Dow Theory Explained in Investment is owned by Harry P. Schlanger. Permission to republish Dow Theory Explained in print or online must be granted by the author in writing.