Understanding Dow Theory for Effective Market Forecasting
Introduction to Dow Theory
Dow Theory is one of the most fundamental theories in technical analysis of the stock market. Named after Charles H. Dow, co-founder of Dow Jones & Company and the Wall Street Journal, it was never officially written by Dow himself but was instead derived from his editorials and writings on the stock market. This theory is based on six basic tenets that assist traders and investors in understanding and predicting market trends.
The Six Basic Tenets of Dow Theory
1. The Market Discounts Everything
According to Dow Theory, the stock market takes into account all available information including current events, future expectations, and market sentiment. This means that the price of a security reflects everything that could potentially affect its value.
2. There are Three Types of Market Trends
Dow identified three types of trends in the market: primary, secondary, and minor. The primary trend is the major market direction over years or months. Secondary trends are corrections to the primary trend and may last for a few weeks or months. Minor trends are short-term fluctuations within the secondary trend.
3. Primary Trends Have Three Phases
Each primary trend has three distinct phases: accumulation, public participation, and distribution. The accumulation phase is when informed investors start to buy or sell, the public participation phase is when the general public follows the trend, and the distribution phase is when informed investors start to do the opposite of the trend.
4. The Stock Market Indices Must Confirm Each Other
This tenet of Dow Theory states that for a primary trend to be valid, it must be confirmed by both the industrial and transportation indices. This means if one index is reaching new highs, the other must reach new highs as well to confirm the trend.
5. Volume Must Confirm the Trend
The theory states that the trading volume should increase if the price is on the primary trend direction. This means that if prices are in an uptrend, the volume should increase (and vice versa).
6. Trends Exist Until Definitive Signals Prove They Have Ended
According to Dow Theory, a trend remains in effect until there is a clear sign that the trend has reversed. This means that investors should assume a trend is in place until it gives them a reason not to.
The Application of Dow Theory in Market Forecasting
Dow Theory is primarily used for long-term forecasting. It is not designed to predict individual stock movements or short-term price fluctuations. Instead, it provides a broad outlook on the market’s direction.
By understanding and applying the six basic tenets of Dow Theory, investors and traders can gain a better understanding of the market’s behavior. This can help them make more informed decisions about when to buy and sell securities, thus potentially increasing their profits and reducing their risks.
Conclusion
While Dow Theory is over a century old, its principles remain relevant today. It provides a foundational understanding of how the market works, helping investors to navigate the complexities of the financial markets. It’s important to remember, however, that while Dow Theory can be a useful tool, it should be used in conjunction with other forms of analysis to make the most informed trading decisions.