Dow Theory Explained
Principle of Trend Confirmation Between Two Stock Indices
Aug 21, 2009 © Harry P. Schlanger
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 both primary and secondary indices
conform to the bull market pattern (Figures 1), and a bear market is not signalled until both indices conform to the
bear pattern (Figures 2).
Fig 1. Dow Theory for a Bull Market
Fig 2. Dow Theory for a Bear Market
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 Dow Theory description
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:
- Short term interest rate bond index used to complement a long bond index
- Dow Jones Transportation index used to complement the Dow Jones Industrial index
- Price of gold used to complement a gold mining share price index
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 reader may be interested in a related article:
Forecasting Major Economic Business Cycles - Watching the Dow/Gold Ratio to Signal Next Market Cycle.
References:
- “Forecasting Financial Markets – Technical Analysis and the Dynamics of Price”,
Tony Plummer. Wiley & Sons Inc, NY. 1991.
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