6 Tenets of Dow Theory – The Modern Study of Technical Analysis

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 theory have a 6 tenants

• Price Discount Everything except act of god

Prices know it all. All possible information and expectations are factored into prices beforehand.

• Market have a three different trend

The PRIMARY TREND: It can be as long as years and is the ‘main movement’ of the market.

The INTERMEDIATE TREND: lasting between 3 weeks to several months, retraces the last primary move some 33-66% and is difficult to decipher.

The MINOR TREND: is least reliable, lasting from several days to few hours, constitutes of noise in market and may be subject to manipulation.

• Market have three different phase

Be it the bull trend or the bear trend, either ways there are three well-defined phases for each. For an uptrend, the phases are Revival of confidence (accumulation), Response (public participation), Over-confidence (Speculation) . The three defined stages of the Primary Bear Trend are Abandonment of hope (Distribution),  Selling on decreased earnings (doubting),  Panic ( distressed selling )

• Averages must confirm

Initially, when the US was a growing industrial power, Dow had formulated the two averages. One would reflect the state of manufacturing and the other, the movement of those products in the economy. The logic was that if there is production, then those who move them about should also be benefiting, and hence new peaks in the industrial average needed to be confirmed by the peaks in the transportation average. Today, the roles have changed, but the relations remain among sectors and so does the necessity of confirmation.

• Volumes confirm trends

Dow was of the belief that trends in prices could be confirmed by volumes. When the movements in price were accompanied by high volumes, they would depict the ‘true’ movement of the prices.

• Easier to continue trend rather than trend reversal

Irrespective of the day-to-day erratic movement and market noise that may be witnessed in prices, Dow believed that prices moved in trends. Reversals in trends are hard to predict unless it’s too late due to the nature and difference in magnitude of trends. However, a trend is believed to be in action unless definitive proofs of reversal emerge.