Understanding Dow Theory: A Key Tool in Market Forecasting
Introduction to Dow Theory
The Dow Theory is one of the most commonly used concepts in technical analysis of the stock market. Developed by Charles H. Dow, co-founder of Dow Jones & Company, this theory is used as a barometer for market trends and is considered a cornerstone of modern technical analysis. Dow Theory is based on the analysis of highs and lows of market indexes and individual stocks.
Basic Tenets of Dow Theory
The Dow Theory operates on six basic principles:
1. The Market Discounts Everything
The theory assumes that all relevant information, including future expectations, is already reflected in the market price. Therefore, the market price is considered the best indicator of aggregate investor sentiment.
2. There are Three Types of Market Trends
According to Dow, the market moves in three types of trends: primary, secondary, and minor. The primary trend, which lasts a year or more, is the major market direction. The secondary trend, which can last from three weeks to three months, is a corrective phase of the primary trend. The minor trend, lasting less than three weeks, is a short-term fluctuation within the secondary trend.
3. Primary Trends Have Three Phases
Dow Theory proposes that primary trends have three phases: accumulation, public participation, and distribution. The accumulation phase is when informed investors start investing, the public participation phase is when the majority of traders follow the trend, and the distribution phase is when informed investors start to sell.
4. The Indices Must Confirm Each Other
For a valid market trend, the Dow Jones Industrial Average (DJIA) and the Dow Jones Transportation Average (DJTA) must confirm each other. This means that if one index reaches a new high, the other should follow to confirm the trend.
5. Volume Must Confirm the Trend
Volume should increase in the direction of the primary trend. In an uptrend, volume should increase when prices rise and decrease when prices fall. In a downtrend, volume should increase when prices fall and decrease when prices rise.
6. Trends Exist Until Definitive Signals Prove They Have Ended
According to Dow Theory, trends, once established, continue until there are clear signs that they have ended.
The Use of Dow Theory in Market Forecasting
Dow Theory is used in market forecasting primarily to identify and confirm market trends. Traders and investors use the theory to make buy or sell decisions based on the identification of primary, secondary, and minor trends.
Identifying the Trend
The first step in using Dow Theory is to identify the trend. This requires observing the highs and lows of the market or a specific stock over a period of time.
Confirming the Trend
Confirmation of the trend comes from observing the DJIA and DJTA. If both indices are moving in the same direction, the trend is confirmed.
Volume Confirmation
Volume plays a crucial role in confirming the trend. If volume increases in the direction of the primary trend, it confirms the trend.
Reversal Signals
A reversal signal is a sign that the trend has ended. This could be a new high or low that is not confirmed by the other index, or a divergence in volume.
Limitations of Dow Theory
While Dow Theory is a useful tool in market forecasting, it has its limitations. It does not provide specific buy or sell signals, nor does it predict the duration or extent of a trend. It is also subject to interpretation, and different analysts may draw different conclusions from the same data. Despite these limitations, Dow Theory remains a fundamental tool in technical analysis and market forecasting.