Friday, July 23, 2021

Dow Theory Explained

The timeline of Dow Theory

Charles H. Dow was the father of the Dow-Jones financial news service in New York.

He was an experienced journalist and the founder & first editor of Wall Street Journal which is one of the most authentic & famous financial publications in the world.

He had invented some postulates on the basis of his observation to understand the market behavior which later became the building block of today’s modern technical analysis.

It was his work only that has now become famous & known as Dow Theory, the basic building block of modern technical analysis. This is the reason he is also known as the father of Technical Analysis.

He also discovered the Dow Jones Industrial Average while doing his research in his journey.

Charles Dow was the first person to create an index that measures the overall price movement of U.S. stocks in the market.

He observed many things by doing experiments & observing the market, but he never invented something which is known to be ‘Dow Theory’.

The only thing which he was doing at that time was writing editorials based on his observations & findings in the market in Wall Street Journal but he never claimed his work as Theory.

The term ‘Dow Theory’ was first used by his friend, A.C. Nelson in his book ‘The ABC of Stock Speculations’ in 1902, after the sudden death of Charles Dow in the same year.

The books which Nelson wrote were based on the works & findings of Charles Dow in his Journal editorials which were published in Wall Street Journal.

After Dow, his successor named William Peter Hamilton headed the Wall Street Journal & continued to write editorials using the postulates of Dows Theory.

He also wrote a book Stock Market Barometer, in 1922 describing basic elements of Dow theory.

After the death of Peter Hamilton in the year 1929, Alfred Cowles (III) successfully implemented the Dow theory into the practical profitable trading in 1934.

Cowles used statistical methods to determine if Hamilton could ‘beat the market. He also developed an index that was a predecessor of today’s S&P 500.

Cowles determine that Hamilton could not outperform the market & concluded that the Dow Theory of market timing results in return that lags the market.

Cowels study provided a foundation for the Random Walk Hypothesis (RWH) & the Efficient Market Hypothesis (EMH).

In 1998 some researchers reexamined the work of Cowel using more sophisticated statistical techniques.

An article by Brown, Goetzmann, and Kumar concluded that Hamilton could time the market very well using Dow Theory & his method is still valid that works very well in sharp market declines and considerably reduced portfolio volatility.

After Hamilton’s death, Robert Rhea further did the research & summed up the previous works & came with a single theory that had become known as Dow Theory.

In 1932, he wrote a book called The Dow Theory: an Explanation of its Development and an Attempt to Define its usefulness as an Aid to Speculation.

He has explained the theory in detail using the articles of Hamilton & formalized it into a series of hypothesis & theorems. This gave birth to what we know as The Dow Theory.

Hypothesis Based on Dow Theory

1. The primary trend is inviolate.
2. The average discount everything.
3. Dow Theory is not infallible

The first hypothesis deal with the manipulation in the market. Rhea believed that the secondary or the minor trend of the market can be manipulated by market manipulators but the primary trend is inviolate.

The second hypothesis, that averages discount everything, is because the prices which we see is the result of people acting on their knowledge, expectations, or interpretation of the information. That means these information or news has already been known to the market & based on that people are reacting.

The third hypothesis is that Dow theory is not infallible. It can be fail if it is not applied in proper way. Neither Dow, nor Hamilton or Rhea claimed that they found a magic formula for profit in the form of Dow Theory.

Dow Theorems

1. Ideal Market Picture (Bottom, Uptrend, Top, Downtrend)

One of the theorems of Dow Theory is that the ideal market picture consists of an uptrend, top, downtrend, and bottom, interspersed with retracement and consolidations. Above fig. shows the picture of ideal market. However, this market picture, of course , never seen in its ideal form. As Hamilton quoted ” A normal market is the kind that never really happens

2. Economic rationale should be used to explain stock market action.

A second theorem of Dow Theory is that economic rationale should be used to explain stock market action.

Dow created both an industrial average and a railroad average. Although we have no record of precise reasoning for doing so, Rhea posited that Dow believed that industrial stocks represented the trend of industry profits and prospects and the railroad stocks represented rail road’s profits and prospects.

The profits and prospects for both of these sectors must be in accord with each other.

3. Prices Trend

The third theorem of Dow Theory is that prices trend. A trend is defined as the general direction in which something tends to move. Because we are talking about markets, that ‘somethin’ is the price.

There are three movements of the averages, all of which may be in progress at one and the same time.

The first, and the most important, is the primary trend: the broad upward or downward movements known as bull or bear markets, which may be of several years duration.

The Second & the most deceptive movement is the secondary reaction: an important decline in a primary bull market or a rally in a primary bear market. These reactions usually last from three weeks to as many months.

The third and usually unimportant movement is the daily fluctuation. (Rhea, 1932)

The Primary Trend

Correct determination of primary trend is the most important factor in successful speculation. There is no known method of forecasting the extent or duration of a primary movement. (Rhea,1932)

The Secondary Trend

A secondary reaction is considered to be an important decline in a bull market or advance in a bear market, usually lasting from three weeks to as many months, during which intervals the price movement generally retraces from 33 percent to 66 percent of the primary price change since the termination of the last preceding secondary reaction. (Rhea,1932)

The Minor Trend

Inferences drawn from one day’s movement of the averages are almost certain to be misleading and are of built little when ‘lines’ are being formed. (Rhea,1932)

A ‘line’ is two to three weeks of horizontal price movement in an average within a 5% range. It is usually a sign of accumulation or distribution.

Concept of confirmation:

As per the Dow Theory confirmation refers to the condition when one average confirms the movement of another average by moving into the same direction.

For example, S&P 500 is moving up & made a new high, & in the same way, Dow Jones moving up with a new high.

Both the averages moving in the same direction forming new highs confirms each other’s trend although there may be a difference in time among them to reach new highs. This is known as the concept of confirmation before the primary reversal can be recognized.

Confirmation in Dow Theory comes when both the industrial & railroad averages reach new highs or new lows together on a daily closing basis. These new levels do not necessarily have to be reached at exactly the same time, but for primary reversal, it is necessary that each average reverses direction & reaches new levels.

‘Conclusions based upon the movement of one average, unconfirmed by the other, are almost certain to prove misleading’. (Rhea,1932)

Although Charles Dow never claimed to have a theory, his works have formed a building block for modern technical analysis.

Although in modern era many tools, sophisticated & advanced technology is present that one can build or test some trading strategies, it is also should be noted that deep groundwork in the basics of market activity is also necessary for any trading philosophy and for that one should know about the prominent work & findings done by Charle H. Dow – Father of technical analysis.

POST AUTHOR

Manish Bhardwaj
Manish Bhardwaj is a full-time trader investor, an analyst for over six years and now, he is also a trading content creator. On a random day, Manish and Sharat were discussing their plans of helping people and both understood that they have almost the same vision. So, they collaborated to take TradingSutra to the next level.

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